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Wednesday, September 13, 2006

Insider Tip: Avoid The Option ARM

There is a very informative article on BusinessWeek Online about the dangers of Option ARMs.

Option ARMs combine an Adjustable Rate Mortgage with a set of payment options that the borrower can select from. These options can range from a fully amortizing payment (all interest plus some principal) to interest only payments and even to payments that do not cover the interest. The first two cases are not bad, though people who would normally select those options could get them without an Option ARM. However, the option borrower generally select is to make very small payments, either to allow them to purchase more expensive properties or to allow them to qualify for a mortgage at all.

The main problem with the low payment option is that since the monthly payment does not cover the interest on the loan the actual loan balance goes up every month. In an Interest Only mortgage the balance stays the same and only the interest is paid for the first several years. On a standard mortgage the loan balance goes down a little each month until it is finally fully paid off since the payment includes the full amount of interest along with some additional principal.

At the end of a short initial time period the Option ARMs convert to standard principal plus interest, which will always cause payments to soar. Plus, since each previous payment added to the outstanding loan balance (since the interest wasn't being covered) the payments are even higher than they would have been with a fully amortizing mortgage right from the start. Many borrowers are caught unaware by this change in payments, and expect their initial payment to last for the life of the loan.

These loans also typically have large penalties for refinancing, sometimes ranging into the tens of thousands of dollars. This makes it much more difficult to find a better mortgage, since with the combination of added principal and fees it is easy for borrowers to end up owing much more than their property is worth. This is commonly referred to as being "upside down". If property values are falling at the same time the effects can be disastrous.

Option ARMs tend to be pushed by mortgage brokers who are trying to make a sale, and often the borrowers are mislead into believing that the payment will not rise above the initial amount. Most of the junk mail mortgage solicitations that people receive that tout '2% interest' or 'cut your payment in half' are actually Option ARMs. Many borrowers are often confused by the fine print as well. A recent Federal Reserve study suggests that a quarter of home buyers don't fully understand basic adjustable rate mortgages, so the number can only be higher for Option ARMs.
There are some cases where Option ARMs make sense. Borrowers who have plenty of money or infrequent large windfalls can use these loans to pay small amounts normally and then make big payments on occasion. These loans can also be used to reduce the total monthly cash flow for people who are investing in property short term. These uses are only for wealthy and financially savvy borrowers and should be avoided by almost everyone.

Bottom line: Avoid the Option ARM. Look into either an Interest Only mortgage or a long term Balloon mortgage. Never trust a mortgage broker, always read the fine print, and if you see the term 'Negative Amortization' RUN.

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