The “option arm” loan program has become one of the most popular mortgage choices for borrowers in the United States in the last few years due to its forgiving payment flexibility. This same payment flexibility has also made it one of the most scrutinized loan programs in history because of its misleading ability to qualify borrowers for a home they truly can’t afford.
The option arm, or pick-a-pay mortgage, is a monthly adjustable rate mortgage, tied to one of the major mortgage indexes, including the LIBOR, MTA, or COFI. The program allows a borrower to pay off their loan balance using four payment options, including the following:
- 15 year term payment (Principle and interest)
– 30 year term payment (Principle and interest)
– Interest-only payment (Usually available first 10 years)
– Minimum monthly payment (Negative amortization payment)
Most borrowers select the option arm for the minimum payment option, otherwise known as the negative amortization option. The minimum payment option allows a borrower to pay monthly mortgage payments that are significantly less than the actual interest-only rate.
The minimum payment on most option arm programs is 1% fully amortized. It seems like a great option, but every time the borrower elects to makes the minimum payment, the difference between the minimum payment and the interest-only payment is tacked onto the balance of the loan.
A borrower can pay the minimum payment until the loan balance reaches 110-115% of the original loan balance, depending upon the rules of the issuing bank or mortgage lender. This allows the typical borrower to pay the minimum payment for roughly the first five years of the life of the loan.
After the borrower reaches 110-115% of the original loan balance, they will lose the minimum payment option, leaving them with the three remaining payment options. After ten years from the start of the loan, the interest-only option typically goes away as well, and the borrower must pay using one of the two remaining payment options.
Typical option arm programs do not have any caps aside from the lifetime cap of 9.95%, though the minimum payment generally increases 7.5% each year until it is no longer an available option.
What many borrowers may not understand is that paying the minimum payment each month is simply a way of deferring interest, not avoiding it altogether. By making the minimum payment each month, the accrued interest eventually stacks up against the borrower, while effectively building zero equity. And after five years of paying the minimum payment, the borrower would have a loan balance above their original balance without the flexibility of the minimum payment option.
This makes the option arm a dangerous choice for homeowners, as once the minimum payment option disappears the borrower has no choice but to pay the interest-only payment. And many borrowers will likely have trouble making the interest-only payment after relying on a much lower minimum payment during prior years.
The only saving grace to this program is housing appreciation and leverage. While the market was hot, real estate investors were using option-arms to keep cash in their pockets, banking on appreciation until they resold the home years, or even months later.
Let’s look at a simple example:
1 Month LIBOR index: 5.330
Margin: 2.65
Fully indexed rate: 7.980%
Loan amount: $400,000
15 year term payment (Principle and interest) = $3,817.99
30 year term payment (Principle and interest) = $2,929.48
Interest-only payment (Usually available first 10 years) = $2,660.00
Minimum monthly payment (Neg-am payment) = $1,286.56
Minimum monthly payment Year 1 = $1,286.56
Minimum monthly payment Year 2 = $1,383.05
Minimum monthly payment Year 3 = $1,486.78
Minimum monthly payment Year 4 = $1,598.29
Minimum monthly payment Year 5 = $1,718.16
Typical five-year interest-only adjustable rate mortgage at 6.75% is $2,250.00.
Monthly savings making the minimum payment = $963.44
As you can see, the minimum payment is dramatically lower than the interest-only payment, but it won’t be around forever. And the minimum payment increases each year, as well as the accrued interest. I’ve seen a lot of lender commercials lately offering option-arm programs under the guise of names such as “Super-Saver program” and “Smart Option”. They tend to highlight the benefits, mainly the cost savings without mentioning the negative implications.
The newest option arm program now is the so-called “assured option arm”, also known as a five-year fixed option arm mortgage. It combines the safety of a five-year fixed product with the flexibility of an option arm. It can be useful for the same reasons I mentioned above, with the security of a fixed interest rate for a small time period. But it’s still a risky loan product, and one that should be approached cautiously as well.
All that said, the option arm program definitely has the potential to save homeowners money, and keep money in their pocket during hard times, but it should be approached cautiously. A loan officer or mortgage broker may recommend the option arm program as a way to keep your payments down, but if you don’t feel you can make the interest-only payments in the future, it’s best you look for something more affordable.
If you can’t make the interest-only payment, you don’t really qualify for the loan. Bottomline.
