Option ARMS

Mortgage and Lending with Mortgage Master

Monday, November 12, 2007

Are Option Arms a Ticking Time Bomb?

A CNN Money article refers to the Option Arm as "ticking time bombs". However, I believe for the right client, this loan makes sense. First let's explain how they work: Every month you get four payment options:

1) The Payment Cap Rate- This is lowest payment. However, it does not even cover the interest accruing. So, the loan amount actually gets bigger instead smaller. This is called negative amortization.
2)The Interest Only Payment- This covers all of the interest but none of the principle. If you make this payment every month, your loan balance will neither increase or decrease.
3) Fully Amortizing 30 Year Fixed Rate Payment
4) Fully Amortizing 40 Year Fixed Rate Payment

As you can see, the Option Arm gives you flexibility and allows you to control monthly cash flow. For example, if you are a commissioned sales person, you can pay the low payment cap payment on months when you have few sales. Then, you can increase your payment, and reduce any deferred interest that may have accumulated , on a month when sales improve.

The problems occur when people, often on a fixed income, take these loans and continuously make the minimum payment. In this case, your loan balance will increase every month and reduce your homes equity. In a market where values are decreasing, this is a double whammy. To make matters worse, most of these loans have a clause that when the loan balance increases by 25% the loan becomes due in full. This basically means you are forced to refinance the mortgage.
In conclusion, for a client that understands the flexibility this loan allows, it can be a good tool to control monthly cash flow. However, it can indeed be a "ticking time bomb' in the wrong hands.

Comments (1)

Keith Stoller
Keith Stoller Tax & Business Solutions - Bakersfield, CA

The 'wrong hands' are pretty much everyone.  That's an exaggeration and it can be a good product for those who need the flexibility.  Too many folks got into them in almost a speculative fashion because they couldn't afford a payment otherwise.  Gambling on things being better in the future folks end up being trapped and the fuse on that timebomb gets ever shorter.

Nov 14, 2007 03:04 AM