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.
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