ARMs with Muscle--Option Adjustable Rate Mortgage Loans
An option ARM is an adjustable rate mortgage with a twist. It combines the lower interest rate benefit of a standard adjustable rate mortgage with the choice of several payment amounts--a minimum payment that can be as low as 1%, an interest only payment, a fully-amortized 30 year payment, or an accelerated 15 year payment. You can decide what you want to pay each month, depending on the ebb and flow of the economy, your lifestyle, and your finances.

Like all adjustable rate mortgage loans, the rate on an option ARM is defined by two components--an index and a margin. The index is calculated from various data that reflects conditions in the financial markets, and changes when the economy does. Lenders and borrowers have no control over financial indices. Conversely, the margin is set by agreement between you and your lender. The margin represents the lender's income and is negotiable. The total of index plus margin is the rate you pay and is also known as the fully-indexed rate.

ARMs carry a lower rate because they are less risky for the lender--when inflationary pressures force interest rates up, the lender still makes money because your rate increases too. ARMs can offer advantages to borrowers as well--when rates drop, the lower interest rate kicks in without you having to refinance as you would with a fixed rate mortgage.

Flexing Your ARM--Enhancements to Option ARMs Option ARMs can be customized with additional features. For example, some lenders will allow you to start with a hybrid or Flex ARM that can be fixed for 3 or 5 years, and then it converts into an option ARM. This allows you a low start rate plus the stability of fixing your payments and reducing your principal during the first few years of the loan.

The Option feature lets you use the equity in your home to keep the payments low if you need to--for example, if rates were very high when the Flex ARM made its first adjustment. If rates are lower or your income is higher, you have the option of accelerating your payoff with a 15 year payment. If you receive a cash sum, such as an inheritance or legal settlement, you can reduce your principal and some lenders will even recalculate your payments based on the new balance if you like. This is called re-casting or re-amortizing your loan.

Other enhancements that can be added are 40 year terms and no income verification (NIV) options. The 40 year amortization helps keep the fully amortized payment lower and more manageable. NIV means no income verification required and is helpful when borrowers' income is hard to verify--for example self-employment income, or a couple who will have one person on the loan but actually has two incomes, or a borrower who receives child support but can't get a canceled check from the ex to document it.

One of the most important features of an Option ARM is the cap. Most loans have caps, and (as with the margin) the lower cap means the better deal. Option ARM caps come in two forms--rate caps and payment caps. The payment cap, generally 7.5%, kicks in each year when your minimum payment is adjusted upwards. For example, a $300,000 loan with a 1% minimum payment rate would begin with minimum monthly payments of $758.57. After a year, the payment would adjust a maximum of 7.5% to $815.46, and the next year to $876.62. This protects borrowers from sudden, perhaps unaffordable increases

The second cap is a rate cap, or ceiling. It is usually expressed as a maximum rate and can vary from 9% to 19%, depending on financial markets when you close on your loan . Knowing the highest your rate could ever go helps you make decisions about when to refinance and prepare for possible payment fluctuations

ARMed and Dangerous--What Can Happen to Unprepared Borrowers
In the recent past, some borrowers were sold and approved for Option ARMs who never should have been. These borrowers were sold on the idea of the minimum payment, which allowed them to purchase more house than they could reasonably afford. Borrowers who take these loans should never see the minimum payment as a long term proposition. Here is what an Option ARM time bomb could look like when the wrong people take on the wrong loan:

A couple takes a $300,000 Option ARM because the minimum payment is only $758.57. A fully-amortized payment at 6.892% would be $1,974.20, and an interest only payment would be $1,723. The couple fails to consider that the difference between the minimum payment and the "real" payment will have to be made up sometime.

They continue to make only the minimum payment each month, and spend the (approximately $1000 each month) difference on travel, restaurants, or new cars. That amount is added to their loan balance--every month. This is called deferred interest or negative amortization. It can't continue forever or the loan would never be paid.

When their balance reaches a negative amortization limit of 125% of the original loan amount, their loan is re-cast by the lender, with a higher balance because of all that interest added to it--as much as $75,000 higher. If the fully-indexed rate was 6.892%, the new payment increases to $2,624.64! The borrowers didn't invest the money they saved, their income didn't go up much, and their house payment has more than tripled after several years. They are in trouble.

Right ARMs--How They Work for Savvy Borrowers
Option ARMs are great for the right borrowers--people who choose a lower payment to achieve a short term objective, not as a long-term lifestyle. Here are some examples of borrowers who have taken Option ARMs for the right reasons and are using them wisely:

A savvy couple chooses a $500,000 Option ARM because they just graduated from medical school and know their income will go up dramatically. The first year, they make the minimum payment. The next year, they are earning enough to switch to the interest only payment, stopping the negative amortization. By year three, they are doing so well that they are accelerating the loan and plan to pay it off in 15 years.

Another smart family has chosen the Option ARM because the parents are highly successful salespeople who get large checks at unpredictable intervals. They make the minimum payments when sales are slower, then they throw extra principal payments at the balance every so often. They use the loan to manage their finances, timing payments with their waxing and waning income.

Still another clever borrower buys a home with an Option ARM, making the minimum payment and taking the difference to make a smart investment each month. The investment does well, making over 10%, and the borrower then uses part of it to pay down the mortgage.

And finally, a couple takes an Option ARM because they just won a legal judgment and expect their money sometime in the next year. The money isn't in their hands yet, and they found a house they had to have, so they have picked a smart loan. The Option ARM minimum payments are affordable, and when the money comes in all they have to do is make a huge principal payment. They ask the lender to re-amortize the loan, and their new, fully-amortized payment is low.

Option ARMs have an upside and a downside. When taken out by discerning borrowers they can enhance your lifestyle and further your investment strategy. It's important for you to assess their financial position before choosing an ARM or any other loan. Examine your income stability and determine your tolerance for risk. If you can't weather a huge payment increase, fixing your rate and payment while 30 year rates are relatively low may be the most sensible option.

Sources:

Federal Reserve Board

First American Real Estate Solutions

Mortgage Bankers Association

CNNMoney

Risk Glossary

About the Author
Gina Pogol writes for an online media company. She holds a B.S. degree in Financial Management and was formerly a loan consultant with Centex and business credit consultant with Experian.