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Here is
what you will learn in this tutorial:
1. What is a flexible payment or option
ARM?
2. How will I know an option ARM when I see it?
3. What are the advantages of an option ARM?
4. What are the risks of an option ARM?
5. How do I protect myself against the risks?
6. Who should select an option ARM?
7. Should I shop for an option ARM? |
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What Is an Option
ARM?
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 provider if the rate adjusts
monthly, and if negative amortization is allowed. If the answer to both
questions is "yes", you almost certainly have an FPARM. Their names are all over
the lot 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
more costly houses than would be possible otherwise, or use the monthly payment
savings for other purposes. You don�t need a list from me of ways to use the
cash flow savings because your loan provider is sure to oblige. What they are
less likely to give you is a sense of the risks you will face down the road.
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 rtes 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.
How Do I Protect Myself
Against The Risks?
Three ways:
1. Measure the Risk:
You can do this yourself using calculator 7ci. It will show you what will happen
to the payment on your FPARM if interest rates follow any of a number of
future scenarios selected by you. An important side benefit is that the
calculator lists the information you need, which you want for shopping purposes
anyway.
2. Minimize the Risk by Shopping For the
Lowest Margin. The margin on your loan is the amount added to the interest
rate index to get your rate. Since the margin affects the rate in months 2-360,
it is the most critical price variable on an FPARM. The lower the margin, the
lower your cost and your vulnerability to payment shock. Note: The margin is not
a required disclosure, so don�t expect that it will necessarily be volunteered.
3.
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. Since the initial payment is determined by the interest rate in month 1,
you should select the highest rate that results in a payment with which
you are comfortable. Asking for a higher rate sounds a little strange, but
remember, the quoted rate holds only for one month.
Who Should Take an Option ARM?
Choose one if your time
horizon is short and you want to maximize your home-buying capacity. Because of
their low initial rates and payments, borrowers can usually qualify for a larger
loan using an option ARM. Since payments will be substantially higher in later
years, you should confidently expect your income to rise in the future. The
option ARM is also a refinance option if your income has dropped and the
alternative to lower payments is default. I do not advise using this instrument
to generate cash flow savings to invest, see
Is Unused Home Equity a Missed Fortune?
Should I Shop For An
Option ARM?
Yes, emphatically, but not for the rate. Your
major focus should be on the margin, because that is what determines your
rate after the first month. Your second priority should be the maximum rate.
Your third priority should be total lender fees.
The good news about monthly ARMs is that lenders
don�t reprice them every day as they do other mortgages, which makes comparison
shopping much easier. You don�t need a rate lock, but ask the loan provider to
specify the margin, maximum rate and fees on paper.
Copyright Jack Guttentag 2005
