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Option-ARMs Carry More Than Just a “Cheap” Rate
By Michael Wayland | May 13, 2008
Boy have I got a deal for you! Just pick this loan, pay only the interest each month, which by the way is only 1% (for a limited time only)! Oh but there’s just one catch…We’ll still be charging you the regular rate, and just adding it to the back end. Sure you’ll have to pay it off eventually but your home is going to keep going up in value right? Oh yeah one other thing, in a few years we’ll stop doing this and start charging you more, maybe up to 4 times what you pay now.
I’m sure most people would not rush out to get the loan described above, but many have been sold to customers, especially in high priced markets. These loans generally go by a more advertiser friendly term, and if you’ve ever been intrigued by promotions for “Option ARMs” or “Pick-a-Payment” mortgages, be wary.
These terms are usually euphemisms for negative amortization loans - and unless you’re careful with how you use them, they can leave you economically depressed and possibly homeless.
What Are Option ARMs or Pick-a-Payment Loans?
Option ARMs are adjustable rate mortgages that generally have a relatively high fully amortizing interest rate, but has up to four payment option features for you to choose from each month. You will receive a new invoice each month giving you four payment options. These options are (1) a low payment rate of between 1% - 3.99%, (2) an interest only payment option, (3) a 15 year amortization payment term option, and (4) a 30 year amortization payment term option. These terms options can vary, but these are used most of the time.
The first payment option, which most people choose since it is the lowest payment available, has a negative amortization feature. This means that instead of your loan balance going down, it goes up. Here is an example: Mr. Rogers has a pay option ARM loan with a 1% minimum payment. His 30 year feature is at 7.00%. Over the year Mr. Rogers only pays that minimum payment. His balance next year will increase by slightly over 6%, so if his balance was $200,000 at the beginning it will now exceed $212,000 the next year.
Minimum payment options, coupled with negative amortizing introductory rates, helped accelerate the growth of real estate in recent years, especially in hot housing markets where even modest homes are beyond reach to the average buyer.
Pay-Option ARMs where originally designed as a tool for sophisticated real estate investors or wealthy individuals, people who may needed free up cash for other purposes for short periods of time. However, in high priced markets, borrowers often use these loans to buy homes they could not otherwise afford as partially witnessed by the recent housing burst in many of these formerly hot markets.
The attractiveness of this product is flexibility, but that flexibility can cause problems for the ill prepared.
Option ARMs two risks for borrowers:
Grossly increasing monthly payments: all borrowers with adjustable-rate mortgages face the possibility of higher payments, but borrowers with option ARMs risk a disastrous increase.
The introductory rate, generally designed to reel in the customer, generally last only a few months. After that, it typically adjusted to approximately 5%. Continue making the minimum payments and the amount of unpaid interest is added to the balance of your loan. Most lenders won’t let you make minimum payments forever. At some point, your lender will “recast” the loan.
This causes a recalculation of your monthly payments, increasing your payments enough to pay off the interest and principal within the remaining term of the loan.
Typically, loans are recast after a set time period, such as five years. But lenders may force the change to come much sooner, especially if interest rates increase quickly. That is because option ARMs include a cap on negative amortization, typically ranging from 110% to 125% of the original loan balance. Once the cap is reached, payments become fully amortizing, even if you’ve held your loan for less than five years.
Paying the standard amortized rate after the initial introductory rate has expired will help minimize the payment shock after your loan is recast. Some studies suggest, however, that more than half of option ARMs borrowers are making only minimum payments. Most of these borrowers face a larger payment shock than they understand.
What’s worse, the lower the introductory interest rate, the higher the payment shock. A Fitch analysis found that borrowers with a 1% initial rate could see their payments rise by more than 100% in less than four years.
Negative amortization: Some borrowers plan for increasing payments is to just sell the house and move. “We’ll just start the cycle over in another place” they might say to themselves. Unfortunately, their plans may run into a problem.
Unlike traditional mortgages, where your loan balance gradually decreases, with a negative amortization loan your balance increases. If home prices in your area stagnate or decline, you could end up owing more on your home than it’s worth which becomes a major problem when you try to sell. If the principal balance is greater than what the home is worth then you will most likely be unable to sell their home without coming up with the difference, this could easily cost you thousands of dollars.
Even a minute increase in your loan balance could leave you in the hole after factoring in real estate commissions and closing costs, which typically consume about 6% to 8% of the proceeds.
A useful tool
Option ARMs provide flexibility for home buyers with uneven incomes, such as those who work on commission or receive a year-end bonus, or investors who may need to free up cash for short periods of time. Unless borrowers are extremely disciplined with your finances they may find themselves in a worse place at the end of an pay-option ARM than at the beginning.
Topics: Articles, Buyer Beware, Tips, protection
