Not a Good Option

Yesterday, one of my clients asked me about Pay Option ARMs.   These loans are probably the most heavily advertised products promoted on the radio.   I cringe every time I hear the announcer boast about the low start rates of anywhere from 1 – 3%.  Pay Option ARMs are marketed by many different names, such as pick-a-payment or cash flow ARMs.   

A newer Option ARM program features a fixed period for the minimum payment and a fixed rate for a five year term.    Every month, when the mortgage payment is due, the borrower has the choice of what kind of payment they would like to make typically based on four different selections. 

Here’s an example of what a fixed period Option ARM could look like.

Option 1:  Minimum Payment--an interest only payment at 3% under the note rate available for the first five years of the loan (NEGATIVE AMORTIZATION).

Option 2:  Interest Only--an interest only payment based on the note rate available for the first 10 years of the loan term.

Option 3:  30 Year or 40 Year Fixed--A full principle and interest payment amortized over either a 30 or 40 year term.

Option 4:  15 Year Fixed--A full principle and interest payment over a 15 year term.

Sounds great, right?  Wrong.  I know a lot of lenders offer this product.  And, at least this option ARM offers a controlled minimum payment for a five year term.  However, how many people are going to make a principle and interest payment when they receive their mortgage coupon? 

Negative Amortization (deferred interest is the nicer term) is the difference between your note rate payment (the actual payment due) and the minimum payment (the low teaser rate).   In this case, every time you opt to make the lower payment, the difference is tacked on to your mortgage balance.   There are ceilings in place that will prevent all of your equity from being gobbled up from your mortgage called “negative amortization cap”.   This loan particular program (option ARMs vary from lender to lender, and this is just one that we could offer, if I don’t persuade you otherwise) features a cap of 115%.    This means that once you’ve made minimum payments long enough to increase your original mortgage balance by 15%, your loan terms will change and you no longer have the minimum payment available as one of your options (this is referred to as “recasting”).

Option ARMs can also impact your credit scores for the worse.   Credit scoring modules give more favorable scores when balances are decreasing and worsen if balances are shown above the credit limit.   If your original mortgage is $200,000 and due to negative amortization, the current balance is $215,000 (for example) your credit scores will be dinged as it appears to the scoring system that you’ve extended beyond over your credit limit on your mortgage.

These loans may work for seasoned investors who do not plan on utilizing the minimum payment option unless, perhaps, they have a rental without a tenant.     However, the majority of homeowners who have Option ARMs don’t fully understand how this animal works or that they are trading equity for lower payments until it sneaks up on them.  It’s not a program that I recommend for my clients when there are so many better programs available that won’t jeopardize home equity.