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18 July 2005
"I want the low payments that are available
on an option ARM, but I don�t know what I should be looking for in shopping for
one. Can you help?"
Reluctantly. I don�t much like the option ARM
because of its complexity and hidden booby traps. However, some borrowers will
ignore all warnings because they are mesmerized by the low initial monthly
payment, calculated at rates as low as 1%. If you are going to take an option
ARM anyway, knowing their major features may save you some grief. Here they are,
in order of importance.
Margin: The Most
Important Feature of an Option ARM
The option ARM adjusts the rate monthly. That
means that the lovely-looking 1% rate you saw in the ads holds for just one
month. In month 2 and every subsequent month, the rate is set to equal the most
recent value of the rate index plus a margin.
For example, assume your ARM uses MTA as the
index and your margin is 3%. In May, 2005, MTA was 2.633%. If your first month
with this loan was May, in June your rate would jump from 1% to 5.633%.
The margin is fixed for the life of any one
loan, but it varies widely between borrowers. This makes it feature number one
on your shopping list. Further, if you don�t shop the margin, the chances are
good you won�t even know what it is until the loan closes. Loan providers
usually don�t volunteer it, and it is not a required disclosure.
Maximum Rate on
an Option ARM
There are no rate adjustment caps on an
option ARM. The only limit set on the rate is a maximum over the life of the
contract. This makes the maximum rate feature number two on your shopping list.
In today�s market, look for a maximum of about 10%, but it can vary some from
lender to lender.
The tradeoff between margin and maximum rate
is a judgment call, but I would put it at about 2.5 to 1. If lender A offers a
3% margin and 10% maximum, for example, and lender B wants a 4% margin, I would
look for a 7.5% maximum from B to make the deals roughly equivalent.
Interest Rate
Index
Most option ARMs use one of 4 indexes
selected because of their relative stability. These are called MTA, COFI, CODI and COSI.
There isn�t a lot of difference between these
indexes. Over the last 12 years, COFI and COSI have averaged 4.0% while MTA and
CODI have averaged 4.2%. (These figures come from www.mortgage-x.com, which is
an excellent source of information on ARM indexes). Hence, in comparing
different option ARMs, you can add .2% to the margin on an MTA or CODI ARM to
make them comparable to a COFI or COSI ARM.
Recast Period and
Negative Amortization Cap
The great appeal of the option ARM is the low
initial payment combined with the 7.5% cap on annual payment increases. The
payment in the early years is not affected by interest rate changes, and in most
cases does not cover the interest. The result is a rising balance, or "negative
amortization".
However, a day of reckoning must come. Sooner
or later, the payment must become fully-amortizing -- large enough to pay off
the balance over the remaining term. This can happen smoothly by successive 7.5%
annual payment increases, or suddenly when the loan reaches the recast month or
hits a negative amortization cap.
On most option ARMs, the payment is recast
every 5 years, though some recast every 10 years. On the recast date, the
payment becomes fully-amortizing, no matter how large an increase that may
require.
Option ARMs also have a limit on how large
negative amortization can go, ranging from 110% to 125% of the original loan
amount. When the balance hits the cap, the payment is immediately raised to the
fully-amortizing level, no matter how large an increase that may require.
All other things the same, a longer recast
period and higher negative amortization cap will delay a payment shock, and the
shock will be somewhat smaller when it occurs. For example, in one of many tests
I ran that are reported on my web site, the payment on an ARM with 5-year recast
rose by 7.5% for 4 years, and by 88% at recast. The same loan with a 10-year
recast rose by 7.5% for 9 years, and then by 61%.
The bottom line is that a longer recast and
higher negative amortization cap are desirable, but I would not accept a larger
margin or higher maximum rate to get them.
Copyright Jack Guttentag 2005
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