Option ARM Mortgage Loan - Home Loan - The Details and Principal Facts

The Option ARM Mortgage Loan - The History, Details and Principal Facts

This article is designed to help you understand the pervasive effects of an Option Arm Mortgage Loan (Pick A Payment Mortgage Loan), also considered a Negative Amortization Mortgage Loan.

An Option Arm Loan (Pick A Payment Mortgage Loan) or Negative Amortization Mortgage Loan isn't something that most people would ask for by its name, but most are attracted to ultra-inexpensive monthly mortgage payments. Call them what you will, Option ARM, Pay Option ARM, Pick-A-Payment ARM Program, Cash-Flow ARM, or other descriptive term, one thing is for certain: these mortgage loan products all feature a payment method where the interest you pay is based on an artificially low interest rate based not on the market condition, but on nothing more than the mortgage lender's marketing ability.

A Little History Lesson about Option Arm (Pick A Payment) Mortgage Loans

Option Arm Mortgage Loans (Pick A Payment Mortgage Loans) which allow for negative amortization aren't new; they date back to mid-1980s, when fixed rate mortgage loans were in the uncomfortably high 9%-12% interest rate range. ARM’s based upon the 11th District Cost of Funds Index, or COFI ("Coffee" ARM’s) were available at comparably attractive rates starting around 6.5%, and featured new and novel ideas like annual payment caps instead of a per-adjustment interest rate limit each year. In fact, the payment caps were actually a big selling point, when mortgage interest rates were considerably more volatile than today: payment caps promised some peace of mind because no matter what happened to interest rates, your required monthly payment would only rise a certain percentage from one year to next year.

Option Arm Mortgage Loans (Pick A Payment Mortgage Loans) in general were still fairly brand new in the mortgage scene and we're not well understood. Many borrowers found out too late that, unlike a rate-capped ARM mortgage (where any charges due to any interest rate changes in excess of 2 percentage points were absorbed by the mortgage lender), pay-capped ARM’s took the difference between what you were paying and what you actually should have been paying, and added it back onto the mortgage loan balance. Worse yet, borrowers took these ARM loans just before a considerable interest rate rise in the COFI which then took that index from the low 6.5% range to nearly 9.5%. After the margins were added, the mortgage interest rates on those loans (which started in the sixes) climbed to around 12%.

Between an ever-rising mortgage loan balance and what seemed to be ever-rising mortgage interest rate, many borrowers found themselves in a lot of trouble. That was even before property values and prices in many areas began to fall, leaving more than a few borrowers with negative equity in their homes: their mortgage loan balance ended up higher than the home's resale value. These borrowers found that selling their homes still left them with a sometimes sizable mortgage debt balance.

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Today's differences in Option Arm (Pick A Payment) Mortgage Loans

Unlike the 1980’s experiences, where those mortgage loans inadvertently became negatively amortizing due largely to the mortgage market conditions, today's mortgage loans have a slightly different twist to them: They begin in a negative amortization situation, where a rising mortgage loan balance is guaranteed. Rather than the interest rate starting at current market rates and perhaps rising over a period time (while the borrower opts to make only a limited monthly payment), these mortgage products come out of the box with a payment interest rate well below that which is actually being charged. As a result of this, the mortgage loan balance starts to increase immediately.

These Option Arm Mortgage Loans (Pick A Payment Mortgage Loans) are intended to be easy on the monthly budget, the guaranteed steady 7.5% increase in your required monthly payment each year will also begin to crimp your overall flexibility over time. If you're considering using one of these monthly payment methods, you'll need to be aware that the initially low monthly payment will not last, and that you should pre-plan plan for higher payments accordingly.

You should also be aware that starting with a big gap in the monthly payment stream tends to produce a mortgage loan balance which grows more quickly than one which starts with an almost fully amortized interest rate. That payment difference will grow as long as the mortgage loan balance continues to increase, by increases in interest rates. As well, that monthly payment gap is only temporarily narrowed by the annual increases of 7.5% in the required mortgage payment amount, and then continues to press up as the loan balance and interest rate grows.

Mortgage Interest Rates steady, due Mortgage Payments are rising?

Unless the rate of interest at which you are making monthly payments quickly approaches the interest rate you are being charged, it's a certain that the monthly mortgage payments you actually owe will increase, and even if the actual mortgage interest rate you are being charged doesn't. The reason is due to the increasing loan balance, which requires a higher monthly payment (if even slightly) to cover the interest and principle which is actually due.

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Protection and Recast Triggers in Option Arm (Pick A Payment) Mortgage Loans

While these Option Arm Mortgage Loans (Pick A Payment Mortgage Loans) do have some limits on how high your interest rate (and subsequent required monthly payment) can rise, these ceilings are typically in the 9% - 12% range. If you've become accustomed to making payments well below that, you could find financial trouble when your rate gets recast.

Early negative amortization mortgage ARM’s usually had just one recast trigger, where your total monthly mortgage payment was adjusted from the limited payment to one which was fully amortized. That usually occurred when the mortgage loan balance climbed, through negative amortization, to 115% - 120% of the original mortgage loan amount. Even with rising interest rates and rising mortgage loan balances, it could take a long time to get to these triggers, but letting a deferment in payment build into a potentially catastrophic increase over a period of years wasn't a good lending strategy. This time around, though, mortgage lenders have developed a slightly different strategy which provides them a little more protection.

A secondary, regularly scheduled recast of your monthly mortgage payment is one of the newer glitches found in some of today's negative amortization mortgage ARM’s. At a set interval, usually 4-5 years, the mortgage lender will adjust your monthly mortgage payment to be fully reflective of the remaining mortgage balance at the current market interest rate. This could cause a substansial increase in your monthly payment, so this is something you should be prepared for. As well, the old 120% or 115% triggers have been decreased, with many contracts allowing for only a 110% recast trigger.

Hitting a Trigger with a Option Arm (Pick A Payment) Mortgage Loan

It's considerably easier to hit a 110% trigger than a 120% trigger, but coupled with a four to five year recast it's safe to say that the monthly payment will rise fairly soon, regardless of the way a given trigger is hit. In fact, using our assumptions puts the outstanding mortgage loan balance at the 110% trigger at about the 51st payment, just over 4 years down the road. Should that happen, the monthly mortgage payment will rise from its minimum $460.90 per month to $710.26 per month - a $250 per month kicker (with an original $100,000 loan amount), and that 54% increase in the monthly payment might be difficult for to manage.

The Equity Gap in a Option Arm (Pick A Payment) Mortgage Loan

Of course, the risks of negative amortization aren’t simply that your mortgage loan balance increases over a period of time, or that you could face staggering increases in your monthly mortgage payment. There can be other additional risks, especially when property values and prices fail to increase or only increase slightly over time (admittedly not today's problem, but no one really knows what real estate market conditions lie ahead for the future). In such a situation, the property's value may increase only a little over time, while your mortgage loan balance is increasing as well. This means that there isn't much equity building, if any, which could be an issue should you want to sell your house (or refinance) down the road.

This is true even if you made a large down payment. If, for example, you bought a house for $105,263 and put 5% down, the mortgage loan amount would be the $100,000 found in this example. If property prices should rise at about the inflation rate expected over the next 4 years (a 3% annual increase) the value of the house would end up at $118,474 after 4 years. Now, typically sales commissions for real estate agents are about 6% of the selling price, which would subtract $7,108 from the gross total, leaving you with $111,366 after the sale of the house. Now, since the mortgage loan balance had increased over that time, the payoff of the mortgage loan (not including any prepayment penalties if applicable) would be $109,276, leaving a grand total of $2,090 in profit after 4 years.

It's not certain that property prices and values will rise or fall over the next few years. One thing is certain, though; the mortgage loan balance will have increased. A lower rate of property value appreciation, no property value appreciation or a downward adjustments in values could leave you in a negative equity situation pretty fast, meaning that, if there is a need to sell, there might be the need to cover some of those costs out of pocket.

The same warning goes is there is hope to refinance. If property price and value appreciation doesn't go your way over the next few years, there may be little equity in the house, and it could be more difficult to refinance at terms favorable enough to be valuable.

While there is nothing specifically wrong with accepting a mortgage loan which allows for negative amortization, it's just these types of mortgage loans aren't for everyone. Borrowers without liquid assets, cash reserves which can be used as needed or required, especially when a recast occurs, may find themselves in a serious predicament, so if you do not have ample reserves at your disposal, you should use caution when considering a negative amortization mortgage ARM product.

We understand that there are some investors and speculator borrowers that are using these products because they prefer a lower monthly mortgage payment, and hope to sell before the increasing cost of the debt and sales charges overwhelm the rising value of property. For some, this strategy has worked well, at least over a few years, when house values have leapt by 9% or more each year. However, it cannot stressed enough that past returns are a poor indicator of future gains, and by no means is equity growth guaranteed.

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