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What is the PayOption ARM?
Imagine an adjustable rate mortgage that allows you to pick
one of four payment options on your monthly mortgage bill. 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 officer if the mortgage has more than oe payment
option. Does 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 map 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 Are the Advantages of an Option ARM?
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 a more expensive home
than they would be able to afford. Other reasons are to use the
monthly payment savings for other purposes, like: paying down the
principle, and amortizing credit card debt. Be aware that they
seldom explain the risks.
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 rates 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. That is why I tell my clients
that unless you have a financial plan for paying the minimum
payment, always pay the Interest Only Option or higher.
How Do I Protect Myself Against The Risks?
First of all, if you can't maintain financial discipline do
not engage in this type of loan. You will be tempted to pay the
minimum payment from day one. When it recasts, you will be stuck
between a rock and a hard place. If you have sound financial
principles, and can adhere to them, go for it.
Make sure your loan officer discloses the margin. The lower
the margin, the lower your cost and your vulnerability to payment
shock. You can also 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.
Terell Jones, Sr. Loan Officer, Group Manager
Terell Jones has been a successful mortgage professional for
several years. He leads a team of loan officers with 1st American
Mortgage, Inc. in McLean, Virginia.
http://www.Mortgage1234.com
 MORE RESOURCES updated Thu. February / 09 / 2012
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