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February 21, 2005, Revised August 1,
2005
Flexible payment adjustable rate mortgages,
usually called "option ARMs",
are the fastest growing mortgage in the marketplace -- and also the least
understood. If you are tempted, here are the essentials you should know before
making the plunge.
What Is an Option ARM?
It is an ARM on which the interest rate adjusts
monthly and the payment adjusts annually, with borrowers offered options on how
large a payment they will make. The options include interest-only, and a
"minimum" payment that may be less than the interest-only payment. The minimum
payment option results in a growing loan balance, termed "negative
amortization".
How Will I Know an
Option ARM When I See
One?
Ask the loan provider if the rate adjusts
monthly, and if negative amortization is allowed. If the answer to both
questions is "yes", you almost certainly have an option ARM. Their names are all over
the lot and include "1 Month Option Arm", "12 MTA Pay Option ARM," "Pick a
Payment Loan", "1-Month MTA", "Cash Flow Option Loan", and "Pay Option ARM".
What Will an Option ARM Do For Me?
Their main selling point is the low minimum
payment in year 1. It is calculated at the interest rate in month 1, which can
be as low as 1%, and it rises by only 7.5 % a year for some years.
The low initial payment allows borrowers to buy
more costly houses than would be possible otherwise, or use the monthly payment
savings for other purposes. You don�t need a list from me of ways to use the
cash flow savings because your loan provider is sure to oblige. What they are
less likely to give you is a sense of the risks you will face down the road.
What�s Are the Risks of
an Option ARM?
For those electing the minimum payment option,
the major risk is "payment shock" � a sudden and sharp increase in the payment
for which they are not prepared.
The rule that the minimum payment can rise by no
more than 7.5% a year has two exceptions. The first is that every 5 or 10 years
the payment must be "recast" to become fully-amortizing. It is raised to the
amount that will pay off the loan within the remaining term at the then current
interest rate � regardless of how large
an increase in payment is required.
The second exception is that the loan balance
cannot exceed a negative amortization maximum, which can range from 110% to 125%
of the original loan balance. If the balance hits the negative amortization
maximum, which can happen before 5 years have elapsed if interest rtes have gone
up, the payment is immediately raised to the fully amortizing level.
Either the recast provision or the negative
amortization cap can result in serious payment shock.
How Do I Protect Myself Against
the Risk of Payment Shock?
Three ways:
1. Measure the Risk:
You can do this yourself using my calculator 7ci. It will show you what will
happen to the payment on your option ARM if interest rates follow any of a
number of future scenarios selected by you. An important side benefit is that
the calculator lists the information you need, which you want for shopping
purposes anyway.
2. Minimize the Risk by Shopping For the
Lowest Margin. The margin on your loan is the amount added to the interest
rate index to get your rate. Since the margin affects the rate in months 2-360,
it is the most critical price variable on an option ARM. The lower the margin, the
lower your cost and your vulnerability to payment shock. Note: The margin is not
a required disclosure, so don�t expect that it will necessarily be volunteered.
3.
Minimize the Risk by Taking the Highest Initial Payment You Can Afford. The
higher your initial payment, the smaller the potential payment shock down the
road. Since the initial payment is determined by the interest rate in month 1,
you should select the highest rate that results in a payment with which
you are comfortable. Asking for a higher rate sounds a little strange, but
remember, the quoted rate holds only for one month.
Should I Shop For an
Option ARM?
Yes, emphatically, but not for the rate. Your
major focus should be on the margin, because that is what determines your
rate after the first month. Your second priority should be the maximum rate.
Your third priority should be total lender fees. See
How to Shop For an Option ARM.
The good news about monthly ARMs is that lenders
don�t reprice them every day as they do other mortgages, which makes comparison
shopping much easier. You don�t need a rate lock, but ask the loan provider to
specify the margin, maximum rate and fees on paper.
Copyright Jack Guttentag 2005
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