Option ARM Mortgages

They're called pay option loans, pick a payment, and the somewhat less descriptive term Option ARMs.  Whatever the name, these innovative mortgages can save borrowers 30% or more on their monthly payments - but at what cost?

In this article we're going to first explain how an Option ARM works including defining all of the terms associated with this type of mortgage.  Next, well talk about the growing demand for flexible payment arrangements and how these exotic mortgages helped to fuel the growth of the subprime lending market.  Then we'll finish up with an example demonstrating the impact this type of mortgage can have on your monthly payments as well as the long-term consequences these pay option loans can have on borrowers.

What is an Option ARM?

By definition an adjustable rate mortgages, or ARM, is a loan where the interest rate on the mortgage is adjusted periodically based on a pre-defined index.  The word "Option" refers to the added payment flexibility these loans offer home buyers.  With an Option ARM, the borrower has the choice of making one of several different payment types on the loan.  For example, the borrower might pay:

• A minimum payment
• An interest-only payment
• A fully amortizing, or fully indexed rate

As we'll see later on, these loans are growing in popularity due to their built-in flexibility - and their ability to keep mortgage payments low.

Option ARM Terminology

The exact terminology you'll encounter with an Option ARM will vary by lender.  But the concepts we're going to explain should help you get a fundamental understanding of how these loans are structured.  At the most basic of levels, an Option ARM has three major features:

• Varying Interest Rates
• Flexible Monthly Payments
• A Recast Cap / Mortgage

Each of these components is explained in more detail in the sections below.

Option ARMS and Interest Rates

Whereas most fixed rate mortgages will quote just a single interest rate on the loan, an ARM has an adjustable rate - one that is tied to a published interest rate index, and as this interest rate varies over time so does the rate paid on the ARM.

An Option ARM takes the concept of an adjustable rate one step further - in fact, there are multiple interest rates bundled with this type of loan:

• Start or Teaser Rate - this is the starting rate for the loan, which is also the lowest published rate for the mortgage.  The start rate is also referred to as the teaser rate because of its attractiveness to the home buyer.
• Index Rate - this rate is common to all types of ARMs and is a published financial index such as LIBOR (London Interbank Overnight Rate), 12-MTA (Monthly Treasury Average), CODI (Cost of Deposits Index), COFI (Cost of Funds Index), or COSI (Cost of Savings Index).  As the index rate changes over time, so will the fully-indexed rate on the loan (as discussed later on).
• Margin Rate - the margin is the difference between the mortgage's actual interest rate and the index rate.  The lower the margin rate, the better the loan from the borrower's perspective.
• Fully Indexed Rate - this is the interest rate used to determine a fully-amortized mortgage.  The fully index rate is equal to the Index Rate plus the Margin Rate.

Monthly Payment Options

Before a mortgage is recast (more on that later) the borrower has the option of making three payment types.  Each of these payment types has a different affect on how much money is owed to the lender - the principal of the loan.

• Minimum Payment - the minimum payment on an Option ARM is based on the starting, or teaser rate.  For example, if the start rate is 2.750% on the loan, then the minimum payment will be based on this rate.
• Deferred Payment - when the borrower makes a minimum monthly payment, the principal on the loan grows and the loan is said to be in a negative amortization or NegAm situation.  Negative amortization occurs because the minimum monthly payment does not cover the full cost (in terms of interest rates) of the loan.
• Interest-Only Payment - a second option the borrower has is to make an interest-only payment.  When this occurs, the borrower is only covering the interest charges on the loan, the principal is not decreasing.  The interest rate for this payment is equal to the Index Rate plus the Margin Rate.
• Fully Amortizing Payment - the final option the borrower has is to make a fully amortizing payment.  The interest charged for this payment is the same as in the case of the interest-only payment.  But unlike the interest-only payment, the fully amortizing payment allows for the pay-down of the principal balance; just like a conventional mortgage.

Mortgage Recasting

As mentioned earlier, an Option ARM allows the borrower to make minimum monthly payments.  When this type of payment is made, a deferred payment occurs because the monthly payment is not large enough to cover the total cost of the loan.  If the borrower continues to make minimum payments, then the loan will grow until it is eventually recast.

The terminology associated with recasting includes:

• Recast Cap - this is the threshold at which the Option ARM is recast and is converted to a conventional mortgage.  The recast cap is stated in terms of percentage of the original loan and is always greater than 100%.  The higher the recast cap, the longer the mortgage is allowed to grow.
• Recast Period - this is an estimate of the time that will elapse - at the minimum payment value - before the recast cap is reached.  The recast period is usually stated in months.
• Recast Mortgage Amount - this is the total value of the recast mortgage.  This value is found by multiplying the recast cap times the original mortgage principal.  For example, if the recast cap is 125% and the original mortgage is $100,000, then the recast mortgage amount is 125% times $100,000 or $125,000.
• Recast Monthly Payment - once the mortgage is recast it behaves more like a standard ARM - meaning it is a fully amortizing mortgage.  The recast monthly payment is calculated based on the fully indexed rate and the recast mortgage amount.

Attractiveness of Option ARMS

The flexible pay options that are featured in these mortgages make them attractive to many borrowers.  The controversy around these mortgages stems from the aggressive marketing efforts of mortgage brokers to the subprime market - individuals with weak credit reports / scores.

The problem occurred because many owners of Options ARMs were making minimum payments each month and were therefore in a negative amortization situation as explained earlier.  As long as home prices continued their upward movement negative amortization was not a problem.  The outstanding principal on the mortgage was increasing, but the value of the home was increasing too.

The exotic mortgage market began to unravel when home prices started to decrease.  Declining home prices, coupled with negative amortization, led to a rapid decrease in the homeowner's equity in these homes.  At the extreme, homeowners found themselves with homes that were worth less than what they owed lenders.

Despite the drawbacks of this type of mortgage, there are some situations where this mortgage is appropriate, for example:

• The borrower might be expecting a large inheritance that can be used to pay off the loan.
• The borrower expects their income to rise quickly as their career progresses or another family member enters the workforce.

Option ARM Example

As promised earlier we're going to finish up this publication by putting together an example that helps explain how all the above-mentioned concepts fit together  This particular example was calculated using the Option ARM calculator found on this website.  In fact, this is the default scenario used for our calculator.

Example - Default Calculator Scenario

In this example we've got a home loan of $200,000, a start rate of 2.750%, an index rate of 3.750%, and a margin rate of 3.500%.  We've also agreed to a recap rate of 110% and a loan term of 30 years.

With these terms and conditions on the Option ARM, the minimum mortgage payment turns out to be $816.48.  The interest-only payment is $1,208.33 and therefore the deferred payment (negative amortization) is $391.85 each month.  If the borrower continues to make these minimum payments, then their recast period would be 51 months.  At that time, the recast mortgage would be $220,000 and the recast monthly payment would be $1,573.94.

By comparison, if the borrower had decided to take out a conventional mortgage for 30 years at a fixed rate of 8.000% their monthly payment would be only $1,467.53 - a savings of $106.41 over the Option ARM.  Furthermore, this homeowner would have an outstanding principal balance of around $192,000 after 51 months compared to the $220,000 for the recast mortgage.  So in this particular scenario the homeowner choosing the fixed rate mortgage would have nearly $30,000 more equity in their home.

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