19 January 2004, Revised 15 February
2005, 1 August 2005
Flexible payment ARMs
carry a variety of names in the marketplace: "1 Month Option Arm", "12 MTA Pay
Option ARM," "Pick a Payment Loan", "1Month MTA", "Cash Flow Option Loan", and
"Pay Option ARM". All refer to an adjustable rate mortgage on which the rate
adjusts monthly with no adjustment caps, and that allows (but does not compel) borrowers to
make very low initial mortgage payments that rise over time.
Most commonly, they are referred to
as "option ARMs", and I will use that term here.
Pros and Cons of
Option ARMs
Their major drawback
is that those who select the minimum payment option may suffer "payment
shock" � a sudden and sharp increase in the payment for which they are
not prepared.
Option ARMs are also very complicated, which
creates a danger that borrowers will take them without fully understanding the
risks. Borrowers who don�t understand option ARMs, furthermore, may overpay, which
increases the risk of payment shock.
The main selling point of option ARMs is the low
payment in the early years. This allows borrowers to buy more costly houses, or
use the monthly payment savings to pay down other highcost debt, make home
improvements, invest in the stock market, and on and on. Loan officers and
mortgage brokers selling option ARMs have long lists of ways to use the cash flow
savings. They may provide little information, however, about how they work and
what the risks are.
Rate Changes on an
Option ARM
The initial interest rate on an option ARM is a
"teaser", it can be as low as 1%, but it holds only for the first
month. In the second month, the rate jumps to equal the "fullyindexed
rate": the most recent value of the index used by the ARM, plus the margin.
Consider a 1% option ARM originated in early
February 2005
that uses COFI as its index, and has a 2.75% margin. At the time of origination,
the last rate available for COFI was 2.118% for December, 2004. The rate in
March will be the value of COFI in
January, 2005 plus 2.75%. If COFI does not change between December and January,
the new rate will be 2.118% + 2.75% = 4.868%. Since the margin affects the
rate in every month but the first, it is much more important to the borrower
than the initial rate.
The interest rate on an option ARM adjusts
monthly, with no limit on the size of interest rate changes except a maximum
rate over the life of the loan. The maximums generally range from 9.95% to 12%
or higher. Almost all option ARMs, however, use rate indexes that adjust slowly to
market changes. COFI is one such slowmoving index, others are COSI, CODI and
MTA.
Payment Changes on an
Option ARM
The minimum initial payment on an Option ARM is
calculated at the interest rate in month 1, and rises by 7.5% a year. While the
interest rate jumps in month 2, the initial payment holds for the year. In the
four years that follow, each minimum is 7.5% higher than the minimum in the
preceding year. The rate in month one thus determines the minimum payments for
the first 5 years.
However, the rule that the minimum payment
rises 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 be fully amortizing. It is
raised to the amount that will pay off the loan within the remaining term at the
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. After the first month, the
minimum payment usually will not cover the interest due and the difference is
added to the balance. All option ARMs have negative amortization maximums, which
range from 110% to 125% of the original loan balance. If the balance hits the
negative amortization maximum, the payment is immediately raised to the
fully amortizing level.
Either the recast provision or the negative
amortization cap can result in payment shock. For a borrower making the minimum
payments, the likelihood of payment shock is larger the greater is the rise in
the interest rate index; the larger is the margin; and the lower the rate in
month one that established the minimum payment.
Borrowers and lenders have no control over
changes in the interest rate index, but the margin and the interest rate in
month one are set in the contract.
Measuring Payment Shock
on an Option ARM
In assessing the risk of payment shock, I
looked at how payments would change on a 30year ARM that used the COFI index
with a value of 2.118% at the beginning. (This was the value of COFI for
December 2004). Two interest rate scenarios were used:
one kept COFI unchanged at 2.118%, the second had it increase by 1% a year for 5
years to 7.118%. I used start rates of 1.25%, 1.95% and 2.95%,
and margins of 2%, 2.75% and 4%. The calculations were done using my Calculator
7ci. The results are in Tables 13 below.
Table 1 shows
that even with a
stable interest rate scenario, borrowers who took the lowest start rate or paid
the highest margin were heavily exposed. A borrower with the lowest start rate
of 1.25% and the highest margin of 4% would face a payment increase of 58.5% in
month 61. Raising the start rate to 1.95% and 2.95% while keeping the margin at
4% would reduce the increase to
40.4% and 18.3%, respectively.
Lenders should not be offering combinations
that result in payment shock in a stable rate scenario. Start rates of 1.25%
should be limited to borrowers who command a margin of 2%, while borrowers who
pay 4% or more should receive start rates no lower than 2.95%.
Any realistic assessment of payment shock
exposure must consider the possibility that interest rates will increase. The
scenario I used, a 1% increase a year for 5 years, is not trivial, yet it is
very far from being a "worst case."
The results shown in Table 2 are scary. Under
the best possible outcome, using the highest start
rate of 2.95% and the lowest margin of 2%, the borrower would be hit with a
payment increase of 58.0% in month 61. At the
lowest start rate and the largest margin, the payment would jump by 175.7% in
month 61! Other results fell between these limits.
Does a Longer Recast Period Help?
A
lender who read the early version of this article wrote me to say that his
option ARM
did not recast for 10 years. The implication was that this reduces the potential
for payment shock. To test this, I repeated the rising rate scenario just as
before but with a recast of 10 years rather than 5. The results are in Table 3.
Comparing the results in Table 3 with those in Table 2, the longer recast does
reduce the payment shock significantly, but only if the start rate is not too
low and the margin too high. Consider the most favorable case, with a start rate
of 2.95% and a margin of 2%. The 5year recast in this case resulted in a
payment increase of 58% in month 61 following 4 years of 7.5% increases. The
10year recast resulted in a payment increase of 27% in month 121 following 9
years of 7.5% increases.
In
unfavorable cases, the differences are smaller because the negative
amortization cap kicks in before the 10 years is over. Consider the least
favorable case, with a start rate of 1.25% and a margin of 4%. The 5year recast
in this case resulted in a payment increase of 176% in month 61 following 4
years of 7.5% increases. The 10year recast resulted in a payment increase of
160% in month 63, just two months later. The balance hit the negative
amortization cap of 125% in that month, making the longer recast period largely
irrelevant.
Advice to Shoppers
Don�t be dazzled by a low initial rate, it holds only for one month. Your major
focus should be on the margin, because that is what determines your rate in the
remaining 359 months. Your second priority should be the maximum rate. Your
third priority should be total lender fees paid upfront.
The critical role of the first month rate is that it determines your payment for
the first year, and for all subsequent years until you either reach a recast
point or a negative amortization cap. The lower the initial payment, the
greater your exposure to future payment shock. Hence, you should select the
highest rate that results in a payment with which you are comfortable.
Option ARMs are relatively easy to shop. Since the rate holds only for one month,
lenders don�t reprice them every day with changes in the market, as they do with
other mortgages. You can therefore afford to be deliberate and take your time.
You don�t have to worry about getting a rate lock, but you should get the
margin, maximum rate and fees on paper.
Table 1
Payment Changes on a
$100,000 30Year Option ARM With Recast in Month 61, Negative Amortization Cap of
125%, at Different Start Rates and
Margins
Scenario: COFI Stable at
2.118%,

Initial Payment 
Maximum Payment 
Number of 7.5% Increases 
Last Payment Increase 
Month of Last Increase 
Start Rate 1.25 % 





Margin 2% 
$333.26 
$518.00 
4 
16.4% 
61 
Margin 2.75% 
$333.26 
$583.02 
4 
31.0% 
61 
Margin 4% 
$333.26 
$705.46 
4 
58.5% 
61 






Start Rate 1.95% 





Margin 2% 
$367.13 
$504.49 
4 
2.9% 
61 
Margin 2.75% 
$367.13 
$568.17 
4 
15.9% 
61 
Margin 4% 
$367.13 
$688.19 
4 
40.4% 
61 






Start Rate 2.95% 





Margin 2% 
$418.92 
$490.35 
2 
1.3% 
37 
Margin 2.75% 
$418.92 
$546.35 
3 
5.0% 
49 
Margin 4% 
$418.92 
$661.74 
4 
18.3% 
61 
Table 2
Payment Changes on a
$100,000 30Year Option ARM With Recast in Month 61, Negative Amortization Cap of
125%, at Different Start Rates and
Margins
Scenario: COFI Rises by 1%/Year, From
2.118% to 7.118%, Over 5 Years

Initial Payment 
Maximum Payment 
Number of 7.5% Increases 
Last Payment Increase 
Month of Last Increase 
Start Rate 1.25 % 





Margin 2% 
$333.26 
$942.66 
4 
111.8% 
61 
Margin 2.75% 
$333.26 
$1042.72 
4 
134.3% 
61 
Margin 4% 
$333.26 
$1227.19 
4 
175.7% 
61 






Start Rate 1.95% 





Margin 2% 
$367.13 
$919.42 
4 
87.5% 
61 
Margin 2.75% 
$367.13 
$1017.61 
4 
107.6% 
61 
Margin 4% 
$367.13 
$1198.76 
4 
144.5% 
61 






Start Rate 2.95% 





Margin 2% 
$418.92 
$883.82 
4 
58.0% 
61 
Margin 2.75% 
$418.92 
$979.14 
4 
75.0% 
61 
Margin 4% 
$418.92 
$1155.19 
4 
106.5% 
61 
Table 3
Payment Changes on a
$100,000 30Year Option ARM With Recast in Month 121, Negative Amortization Cap of
125%, at Different Start Rates and
Margins
Scenario: COFI Rises by 1%/Year, From
2.118% to 7.118%, Over 5 Years

Initial Payment 
Maximum Payment 
Number of 7.5% Increases 
Last Payment Increase 
Month of Last Increase 
Start Rate 1.25 % 





Margin 2% 
$333.26 
$1102.80 
8 
99.5% 
98(N) 
Margin 2.75% 
$333.26 
$1145.94 
6 
122.8% 
80(N) 
Margin 4% 
$333.26 
$1242.09 
5 
159.6% 
63(N) 






Start Rate 1.95% 





Margin 2% 
$367.13 
$1135.74 
9 
61.4% 
121(R) 
Margin 2.75% 
$367.13 
$1156.53 
7 
89.9% 
90(R) 
Margin 4% 
$367.13 
$1246.77 
5 
136.6% 
68(N) 






Start Rate 2.95% 





Margin 2% 
$418.92 
$1017.19 
9 
26.6% 
121(R) 
Margin 2.75% 
$418.92 
$1193.38 
9 
48.6% 
121(R) 
Margin 4% 
$418.92 
$1254.34 
6 
94.0% 
78(N) 
Note. R means that the
last payment increase was the result of recast, N means it was the result of the
negative amortization cap.
Copyright Jack
Guttentag 2005
