They're called pay option loans, pick a payment, and the somewhat less descriptive term Option ARMs. Regardless of 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 the terms associated with this type of mortgage. Next, we'll 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 a borrower's monthly payments, as well as their long-term consequences.
By definition an adjustable rate mortgage, or ARM, is a loan where the interest rate is adjusted periodically based on a pre-defined index. The word "option" refers to the added payment flexibility these loans offer homeowners. With an Option ARM, the borrower has the choice of making one of several payment types. For example, the borrower might pay:
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.
The exact terminology encountered with this type of loan will vary by lender. But the concepts should help consumers to get a fundamental understanding of how these loans are structured. At the most basic of levels, an Option ARM has three major features:
Each of these components is explained in more detail in the sections below.
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. As this index varies over time, so does the rate paid on the ARM.
An Option ARM takes this concept one step further. In fact, there are multiple rates bundled with this type of loan:
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 effect on the principal of the loan.
As mentioned earlier, an Option ARM allows the borrower to make minimum monthly payments. With this type of arrangement, a deferred payment occurs because the monthly funds are not large enough to cover the total cost of the loan. If the borrower continues to make minimum payments, the loan will grow until it is eventually recast.
The terminology associated with recasting includes:
The flexible pay options featured in these loans make them attractive to many borrowers. The controversy around these mortgages stems from the aggressive marketing efforts of brokers to the subprime market; those individuals with weak credit reports or scores.
A problem occurred because many owners of these loans were making minimum payments each month, and were therefore in a negative amortization situation. 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. This decrease, coupled with negative amortization, led to a rapid decrease in the homeowner's equity. At the extreme, borrowers found themselves with homes that were worth less than what they owed lenders.
Despite its drawbacks, there are some situations where this mortgage is appropriate, for example:
As promised earlier we're going to finish this article with an example that explains how 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.
In this example, Bill has 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%. Bill also agreed to a recap rate of 110% and a loan term of 30 years.
With these terms and conditions, the minimum mortgage payment turns out to be $816.48. The interest-only payment is $1,208.33, and the deferred payment (negative amortization) is $391.85 each month. If Bill continues to make these minimum payments, his 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 Bill had decided to take out a conventional mortgage for 30 years at a fixed rate of 8.000%, his 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. In this particular scenario, a homeowner choosing the fixed rate mortgage would have nearly $30,000 more equity in their home.
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