15 Jun, 2007 in
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An option adjustable-rate mortgage is a complex type of hybrid mortgage originally designed for a narrow segment of people: sophisticated borrowers with inconsistent incomes. But because an option ARM has such a low initial payment, it became popular during the housing boom, with about $250 billion in option ARMs issued during the past three years.
More recently, the loan’s appeal has dimmed amid higher short-term interest rates, as well as horror stories. But the mortgage is still being marketed aggressively.
If you are thinking about taking out an option ARM, here are some important tips:
Know your options. Each month, an option ARM gives you a choice of four payment amounts:
- The highest amount, if paid every month, would be enough to pay your loan off in 15 years.
- The next-highest amount is calculated to pay off the loan in 30 years.
- Pay only the interest accruing that month – and none of the principal.
- The minimum payment / teaser – is the most tempting, and usually the one that’s advertised. It is calculated based on a “teaser” interest rate that can be as low as 1 percent or 2 percent a year. But after the first month, if you make the minimum payment, not only are you not paying down the loan, you’re not even paying all of the interest that’s accruing. As a result, your total debt is actually increasing.
Understand the teaser. The artificially low initial interest rate on an option ARM is known as the teaser rate because it’s the number that lures you into taking the loan. But although the payment may be fixed for several years, the teaser rate expires after the first month. The additional interest is added to the mortgage balance.
Borrowers are often tricked into believing that the teaser rate will last for as long as the fixed minimum payment does.
Examine your income. Option ARMs can be good for borrowers whose take-home pay varies widely. For instance, a good candidate might be a salesperson who earns huge commissions in some months and not much in other months or a person who reliably gets a large year-end bonus. But if you have a fairly stable income, an option ARM is probably not for you.
Don’t plan to refinance. If you’re thinking about getting an option ARM and refinancing if the payments get too high, don’t count on it. Three things could keep you from refinancing, particularly in today’s market:
- You may no longer have sufficient equity. If you borrowed $100,000 on a $120,000 property, for example, making only minimum payments could put your loan balance above the value of your home, especially if it has not appreciated in the meantime.
- If you struggle to make payments before trying to refinance, that could lower your credit score, making it more difficult – and costly – to refinance.
- Your option ARM will probably have a prepayment penalty, which would boost the cost of refinancing the loan.
Read the documents. The only way to really know how your mortgage works is to read the loan papers. That can mean making your way through a 2-inch stack of documents. Even then, you may run into trouble.
Consumers can go to a loan broker to help them find the best deal among competing mortgage lenders.
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