Once I googled for Option ARM and the top search result read Nightmare Mortgages. Very … hmmm … intriguing, isn’t it?
Well, as I always say, you have to have a clear idea of how a mortgage plan works. Once you are sure, that you understand it, you can decide for yourself, whether such an Option is likely to become your nightmare.
The Option Adjustable Rate Mortgage offers the borrower several options for each monthly payment. The mortgage contract states what exactly variants are possible. The first one or two months, depending on the contract, the borrower is entitled to a very low interest rate and a very low period payment amount. When this introductory period expires, the rate goes up and each period payment is paid according to the selected option. The usual available options are: a minimum payment, or an interest-only on a 30-year mortgage payment, or a fully amortizing 30-year mortgage payment, or a fully amortizing 15-year mortgage payment. That means that one month you can pay only the interest and the next monthly payment may equal to a monthly payment of a 30-year Adjustable Rate Mortgage with your balance and the rate of the day. If you choose the minimum payment option, which is a really low amount – just imagine what you can do with the “saved” money!!! Where’s the nightmare, you say? Well, it is already there, but it is not obvious yet, that’s why a lot of people make a mistake and agree to these terms without reading the fine print thoroughly. The word “saved” is in quotes only when you read it, not when you hear the broker say it…
Option Adjustable Rate Mortgages have been on the market since the early 1980′s. Originally created for quite well-to-do people, they provided the versatile flexibility of early payments and caused no problems later, when the payments increased. In the course of time, the instability of the real estate market made the traditionally popular Fixed Rate Mortgages unaffordable to many families. Banks started looking for alternatives and here came Their Knight in Shiny Armor – Option Adjustable Rate Mortgage to All. The only problem with it was (and still is) that brokers, for the reasons of their own, did not always bother to explain every detail of the deal to their customers. Sad, but true. Unaware people found themselves trapped in a debt they could barely (if at all) pay off.
So, what’s the big picture?
First of all, the Option Adjustable Rate Mortgage is an Adjustable Rate Mortgage, i.e. after the first month or two of the super low teaser rate, the rates start to be generated in a regular way from the selected index plus the margin. The first month is usually the bait (excuse my language). The broker offers his customer an Interest Rate of around 1.5%, as opposed to the average of, say, 6.5% for a Fixed Rate Mortgage, and a very low fixed amount as the minimum period payment. Chocolates and cakes…. Fascinating, isn’t it? That’s just the right moment to realize, that free cheese, chocolates and cakes, are only found in a mousetrap.
The Option Adjustable Rate Mortgage is a monthly adjustable mortgage with no adjustment caps. The only constraint is the top limit of the rate allowed during the whole life of the loan and the margin. Hypothetically, the interest rate on your loan can jump from 1.5% to 12% in one month! Luckily, most Option Adjustable Rate Mortgages stick to the rules of conventional Adjustable Rate Mortgages and use indexes and margins to derive the rates. The rate catches up with the market already in month two (sometimes three) and you should immediately reconsider the option of your monthly payment. If you stick mechanically to the minimum payment established at the mortgage origination, you can get yourself into a big trouble. The minimum monthly payments can be raised by only 7.5% a year – that’s the payment cap with most Option ARMs. Thus, the initial period minimum payment amount calculated from the super low introductory rate, will be fixed as your option of the minimum payment for at least a year, while the rate will continue to rise. Normally, a period payment should be able to both amortize some of the principal and pay the interest. If you choose to pay the minimum only, it may (and very likely will) so happen that the amount will be too low to accomplish this purpose. It will cover the principal part of the payment, but fail to pay most of the increased interest. All the sums of the underpaid interest will be added to the balance! The overall balance will increase – instead of paying the loan down you’ll be underpaying it up! Already after one year, when you get your first chance to adjust your minimum payments, you’ll have to deal with a debt bigger than your original loan. This situation is known as negative amortization. Not pretty!
Negative amortization is not an endless process that builds up your debt to 1000%. It strikes sooner. Most Option Adjustable Rate Mortgages have a negative amortization cap of 110 percent to 125 percent of the original loan amount. When the mortgage balance hits this bar, the mortgage minimum payment gets “recast” – it is raised to the amount sufficient to pay off the loan within the remaining term. Taking into account the increased balance, you literally have to face a bigger loan with a shorter term. The minimum payment imposed upon you by the bank from that point on will be a lot higher. A payment shock.
Now. There there. Take a deep breath. You must be wondering why people go for it anyway? Two reasons, I’d say – unawareness and sound knowledge. In the former case, under-informed borrowers get themselves into trouble with the minimum payments; in the latter case, people know how to avoid the unnecessary risks and feel sure of their, pretty much their own, payment plan.
A few words about how to join this jollier club.
First of all, never forget that it is an Adjustable Rate Mortgage. If you really intend to pay it off, let it stay that way and choose either the 30-year or the 15-year period payment as your monthly payment option. These payments do amortize your loan. They make your Option Adjustable Rate Mortgage pretty much similar to the conventional Adjustable Rate Mortgage, with a little bit of some very limited freedom to pay less (the minimum payment or Interest-Only) from time to time to clear yourself some extra cash for other urgent needs. With a good calculator you can estimate how many minimum payments and how often you can afford.
Minimum payments are subject to recast every 5 or 10 years regardless of the fact whether the negative amortization cap has been reached or not. People who pay only the minimum, actually race against time: what will happen first – will the negative amortization cap be reached and they get recast payments or will 5 years manage to elapse before it happens? Even if somewhere halfway these borrowers realize what is going on, there is little they can do. Steep penalties prevent them from refinancing.
