Is an Option Arm Mortgage Your Best Choice?
Most consumers need to have this product explained. Introduced by Washington Mutual and World Savings over a decade ago this program this type of loan is often referred to as a Pay Option Arm, Option Arm or Cash Flow Loan. It was (and still is) greeted with high appraise by some industry professionals while others loathe it. For the average homeowner this is probably the most difficult loan program to truly understand since it involves 4 different payment options and there is always a possibility of negative amortization.
Before we dwell into the different payment options you must understand that option ARM loan programs are not for everyone however they do serve a very valid purpose for a select group of homeowners. Short term homeowners, self employed individuals and real estate investors seem to make up the greatest demographics behind these loan programs.
So What is the 1% Payment...
The advertisements hear on the radio and published in newspapers usually refer to 1% payments but the actual interest rate is much higher. the 1% is simply one of your payment options. It's a minimum payment based on 30 year principal and interest amortization at 1%. If you only pay the minimum (and many people do) than the remaining interest accrued will simply be tacked on to your loan balance. Essentially, the longer you only pay the minimum payment the larger your loan balance grows.
What are the Payment Options...
Option Arm loans come standard with four (4) payment options however a couple of these options are only available if the full principal and interest payment is less than the minimum payment due.
Additionally, there are some safeguards built in to these loans to reduce your risk exposure from rising interest rates. These safeguards are generally:
- A Fixed Interest Rate for an initial 1-month period
- A Minimum Payment Amount that Adjusts on an Annual Basis
- A Payment Change Cap
- A Lifetime Interest Rate Cap
The Payment Change Cap limits how much your minimum monthly payment can increase or decrease from the previous minimum payment. You should note that many lenders provide an exception in your note so this cap is not in effect during certain periods of your note.
Option 1 - Minimum Payment
This option (known as the Minimum Payment Option) provides the greatest monthly cash flow savings. Your payment will change annually and is initially calculated using the initial interest rate for the first 12 months. After the first year, this payment is usually re-calculated annually and based on the outstanding principal balance, remaining term and current market rates. Before applying for an option arm loan make sure to ask what index your loan is based on and the margin (see below). A Payment Change Cap* is in effect with most programs usually capping any change to within 7.5% of your original payment (annual increase or decrease)
Option 2 - Interest Only Payment
Just like the popular interest only mortgage programs this option helps the homeowner prevent any avoid deferred interest by paying the minimum monthly payment plus any additional interest accrued during the month.
Option 3 - 15 Year Fixed Rate Payment
This option allows a consumers to apply the largest contribution towards principal and term reduction. The payment required to satisfy this is calculated by amortizing your loan based on a 15-year term from the first payment due date.
Option 4 - 30 Year Fixed Rate Payment
This is the fully amortized payment based on a 30-year loan and is calculated each month based on the prior month's interest rate, loan balance and remaining term. The biggest advantage to this payment option is that the payment pays all of the interest due and reduces your principal.
It is right for you? Ask yourself...
- Are you comfortable with just paying a minimum payment understanding that your loan balance may grow?
- Do you fully understand the concept of a minimum payment and how it relates to negative amortization?
- Do you possibly foresee needing a home equity loan in the future? If so, you need to learn more about how Negative Amortization can hurt your ability secure a home equity line.
Ask Your Lender...
- What Index is used? This will help you determine what financial index is used as a base for calculating your interest rate. Such indices include MTA, COFI, COSI and the LIBOR index.
- What is the Margin? By adding the margin to you loan's current index rate you can know calculate what the real rate of interest is for the loan program in today's market.
- Can You Make Extra Principal Payments? Be very careful and make sure you ask this question. Mortgage lenders and brokers earn quite a large sum of money for attaching a prepayment penalty to these programs so if you are against having a prepayment penalty make sure you take the time to ask. (Most lenders will allow you - even with the prepayment penalty - to still pay up to 20% a year without triggering the penalty clause).
