"Option Arm" Loans—The Not-So-Good You Need To Know
Seems like we all want the latest and hottest "thing" these days, and even some mortgage loans are no exception. The lending industry seems intent on seeing everyone in America become a homeowner by introducing new adjustable rate loan products that give a false impression that home ownership is both cheap and affordable despite soaring home prices.
Contrary to the good advice of many financial experts, more and more would-be and current homeowners are being lured into loans that can backfire and possibly even render you homeless in a few years if your income cannot keep pace with increasing monthly mortgage payments and a rising interest rate environment.
One of these adjustable loan products introduced to the average consumer is the "Option ARM" home loan, also known by several names like "Pick-A-Pay Loan", the "Flex Pay Loan", "Flex Option ARM", and "Pay Option ARM", among others. It's other alias doesn't sound quite as attractive: a negative amortization loan ("neg-am" loan for short).
Lenders use the low starting rate or sometimes the low introductory monthly payment in their advertisements for these loans as a hook to get your interest. "Just imagine," they say, "having a 30—year home loan with an interest rate as low as 1.25%", or "a $500,000 home loan for just $1666 a month!". Some even go so far as to advertise these loans with no closing costs! Wow! Sounds like a great deal, so what's the problem?
While these advertisements are not inherently false, they're only short-term truths. As with any longer-term financial commitment like a mortgage, the "devil is in the details" as they say.
For those of you with short attention spans (or detest long articles), I've summarized the 5 most important reasons most homeowners should steer clear of the Option ARM loan:
1. Your mortgage payment will increase over time. If you like the security of knowing what your payment will be from month to month or year to year, this is NOT the loan for you because it is based on an adjustable rate index, and there are forces at work in this type of loan beyond your control that can drive your payments up to an unaffordable level in a relatively short period of time or in certain market conditions. A $350,000 Option Arm Loan at a 1.25% start rate based on the current MTA Index (3.88%) with a 2.75% margin has an initial monthly minimum annual payment of $1166.38. Even with the standard 7.5% annual payment cap in place, in year 5 the same loan will cost you $1557.66 per month. That's a difference of nearly $400 in increased monthly minimum payments in just 5 years. That's assuming the loan doesn't negatively amortize to the maximum allowed over that period of time. If it were to achieve it's "neg cap", your payment could increase far beyond $400 per month.
2. You could end up owing more on your home loan than you started with. This is the effect of negative amortization. Negative amortization occurs when the mortgage payment is less than the interest due and causes your loan balance to increase rather than decrease, a byproduct of the Option ARM loan. If you want the benefit of a lower interest rate than those of fixed-rate loans, get a conventional adjustable rate mortgage loan with the option of making interest-only payments and avoid any loan that contains a provision for negative amortization.
3. There's always a prepayment penalty attached to Option ARM loans. An Option ARM loan is the worst possible loan to be locked into for a long time, yet these loans always come with a stiff prepayment penalty. Lenders don't want borrowers jumping in and out of these loans for the low start rates, and brokers make HUGE rebate earnings (up to 3.5 points) from lenders for selling extended penalty terms. Borrowers with decent credit can get any other loan product available without being forced to accept a prepayment penalty.
4. Obtaining a 2nd mortgage can be extremely difficult when you have an Option ARM 1st loan. This is one of the least known facts about having an Option ARM loan. Second mortgages are far and away easier to obtain when your first mortgage is anything other than an Option ARM loan. I won't go into all the details here, but suffice it to say that the potential for an Option ARM loan to negatively amortize places a second lender in a more precarious position than when loaning behind any other loan type, and many won't do it or otherwise restrict the amount of the second loan to take into consideration the full negative potential of the first mortgage. And in cases where the Option ARM first loan exceeds $1 million dollars, there are only a select handful of lenders that will assume that risk. Call me if you need a 2nd mortgage behing a neg-am 1st loan. We have lenders for these situations.
5. Finally, an Option ARM loan is only for the most financially disciplined homeowner who can both afford to make the different payment options (and the discipline to do so) and have a decent equity cushion in the property. The Option ARM loan was never intended as a means for someone living on average hourly wages or salaried income to afford a home, especially over the long haul. Certainly as a short-term loan option it's not too bad.
I believe that most people when given the choice between making a loan payment of more or less will invariably opt to pay less as often as possible, making the Option ARM loan the worst loan for most people due to it's inherent risks. Let's face it, if you can only afford the interest-only payment on this type of loan, you'll never need the options of paying 15 or 30-year amortizing payments, so stick with a loan that offers an interest-only payment option without the potential pitfall of negative amortization.
After reading the above you might think I'm biased against the Option ARM loan, and you'd be right to a certain degree. Of all the loan options available in today's marketplace, there is no other loan that is as complicated, risky, or downright unnecessary to all but a handful of very disciplined homeowners who know how to take advantage of this type of financing, such as self-employed, high-commission earning homeowners who need the added flexibilty of a loan like the Option ARM.
Everyone else should forget about low introductory rates and stick with a good old fashioned fixed rate loan.
