One of the most popular yet misunderstood mortgages available today is the option-ARM. There are messages everywhere (especially on the web) advertising ridiculously low rates and payments like, “get a $500,000 mortgage for only $1000 a month!” or, “rates as low as 1%!”
Sound too good to be true? In a way, it kind of is.
How an option-ARM mortgage works:
Each month you are given the choice of 4 payments to choose from: the minimum payment (which is the one that’s always advertised), an interest only payment, a 30-year fixed payment, and a 15-year fixed payment. You can choose to make the minimum payment one month, the 30-year fixed payment the next month, or however you’d like to mix and match.
The minimum payment is calculated at a super low interest rate called the minimum payment factor. In contrast, the interest only, 30-year fixed, and 15-year fixed payments are calculated off of the fully indexed rate which is a much higher rate, and corresponds to regular loans.
Here’s a typical lending scenario:
John gets an option-ARM for his new $250,000 home. His minimum payment is $924 calculated off an adjustable minimum payment rate of 2%. His interest only payment is $1458 calculated off the fully indexed adjustable rate of 7.00%. His 30-year fixed option payment is $1,663 and his 15-year fixed option payment is $2247, also calculated off of the same fully indexed adjustable rate of 7.00%. Each month John gets to choose which payment he will send to the bank.
Now, if John chooses to only make the minimum payment every month, he will go negative $534 each month, which is the difference between the minimum payment and the interest only payment.
By doing this, his loan balance is will be going up instead of going down. The reason he will go negative is because the real rate that the lender is charging him is the fully indexed rate.
If John decides to pay the interest only payment he will not go negative, but his loan balance will stay the same because he is only paying the interest. If he decides to make the 30-year fixed payment the loan will pay off in 30 years (since he is paying principle and interest) and of course it will pay off in 15 years if he takes that option.
So why on earth would anyone choose this loan? Well, for a few reasons.
Reasons to get an option-ARM:
First, if you are buying an investment property and looking to leverage your existing funds, an option-ARM can be a great tool. This is especially true in areas that have low rent and high values making monthly cash flow difficult.
It can also be good for people with seasonal income or self-employed individuals with significantly fluctuating income. Borrowers can make the minimum payment when funds are tight, and then make a big payment when the dough is rolling in, to offset the negative balance they had previously racked up.
This loan can be a great tool for the right person, but certainly not for everyone. It must be someone who is financially savvy, who understands how the loan works and how to properly manage their funds. Because of this, I don’t recommend this loan for the majority of borrowers.
Reasons NOT to get an option-ARM:
If you are thinking of getting this loan and only making the minimum payment every month, watch out. When your loan balance gets to either 110%, 115%, or 125% (depending on the lender) your loan will recast.
When this happens, your lender will look at how much is owed and then recalculate the payment so that the remaining balance will be paid off in 30 years from the date you obtained the loan.
Let’s go back to John. After 2 years his loan recasts and his new payment is $1869 (assuming his rate is still 7.00%; the rate could be higher or lower at this point since it is adjustable).
At this time John no longer has any other options. That is his only choice unless he can refinance. If the market has been strong in John’s neighborhood and his home is worth more than what he owes, then he will be ok. If the market has been slow and his home is worth less than what he now owes then he will have a pretty tough time finding any lender willing to help him.
An option-ARM is a great loan for the right borrower, but you can see how it could be easy to get in over your head. If you are considering getting an option-ARM, make sure your lender has discussed with you how the loan works and what its positive and negative aspects are.
Please feel free to contact me with questions you may have regarding option-ARMs or any other type of mortgage.
Chelsea Collier is a licensed home mortgage specialist in both Oregon and Washington, as well as a frequent contributing writer for OHM. Please don't hesitate to contact her with any questions you may have about financing (or refinancing) your home.
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