Option ARM Loans

An option ARM is a variable rate mortgage that gives the borrower options for any given month. The borrower may chose to make:

1. A specified minimum payment.
2. A payment to cover only the interest.
3. A 15 year or 30 year fixed rate payment.

An adjustable rate mortgage is on where the interest rate charged is linked to an economic index. If the index goes up the interest rate charged on the mortgage interest rate will increase (advantageous to the lender) but if the index goes down then the interest rate charged will go down (advantageous to the borrower). The most common economic index used by option ARM lenders is the one year Treasury bill.

As well as the economic index the lender charges a margin. This margin is fixed for the length of the mortgage.

As an example, if the index was 4% and the margin 2% then your interest rate would be 6%. If the index were then to change to 4.5% the margin remains 2% and the new interest rate on your mortgage would be 6.5%.

Since the mortgage principal can increase if minimum payments are made (negative amortization) the lender sets a cap on how high the principal can go. The cap usually is 110% of the original mortgage. Once this is exceeded the lender will increase the minimum monthly payment so that you pay down the mortgage principal.

Option adjustable rate mortgages are useful for some borrowers, but are not for everyone. A borrower with a steady income is probably better off to avoid this kind of mortgage. The type of person that can benefit from this type of mortgage is one who has irregular income, such as those who have seasonal income, work on commission, or who receive large bonuses. During lean times they can pay a minimum amount and then during large income periods go back to a 15 year schedule to pay off the mortgage.

Advantages:

• The ability to pay more or less if your income source varies from month to month.
• Minimum monthly payments can be very low. Beware of very low teaser interest rates that last for very short periods of time. The payment is set low based on this low rate but the interest rate will soon increase to normal market rates. This can result in a situation where the payments, calculated on the low rate are not large enough to cover the interest charged calculated on the higher market rate.

Disadvantages:

• If the payment made is less than the interest charged then the difference is added back into the principal, this is called negative amortization. If not careful the borrower can end up owing more than the mortgage they started out with.
• If the mortgage amount increases past the principal cap, the minimum payment required will increase, sometimes significantly.
• If the housing market goes into a decline and you have been making minimum payments you may find yourself owing much more than the market value of the house. In this case you will not be able to sell the house for enough to pay off the mortgage.