The Pay Option ARM is taking the mortgage industry by storm. It is an easy to sell product that, on the surface, allows homeowner's tremendous flexibility in how they choose to pay their mortgage; one option is to pay a minimum payment of only a couple hundred dollars. It is marketed as ideal for people with fluctuating incomes, such as real estate professionals, but it has a broad appeal to borrowers across the lending spectrum. However, many of the benefits so aggressively touted by loan officers are a little misleading and the Pay Option ARM has a few major disadvantages.
First, let's discuss what a Pay Option ARM is and how it operates. The product does just what it sounds like - offering borrowers a choice of payment options each month. Generally, there are 4 options:
- A minimum monthly payment
- An interest only payment
- A payment based on 30 yr (or 40 yr) amortization
- A payment based on 15 year amortization
The minimum payment is, of course, the lowest payment option you have. This is where most people get into trouble with Option ARMs. The minimum payment is a full principal and interest payment that is based on the introductory rate the first year or the "recast rate" in subsequent years. The recast rate is simply an adjustment to the minimum payment rate.
The problem with the minimum payment is that the introductory rate is only good for 30 days. Beyond that, the higher rates apply. When a customer makes a minimum payment, they are not "off the hook" for the greater interest due. Rather, that interest accrues and is added to the principal balance - which can easily be several hundred dollars a month. In mortgage terms, it is called negative amortization. Said plainly, the client will actually owe more on the mortgage than they did on the day they signed the closing papers.
When this happens, all of the payments (even the minimum payment) increase as the loan amount is now larger. In addition to that, many Option ARMs do not have a fixed rate introductory period; they start adjusting immediately. This is not good in a climate of rising interest rates. For the borrower, the low payments they saw on the mortgage application begin a rapid and dramatic ascent.
What happens if the borrower based his budget on the lower payments indicated on the loan application? Worse, what does it do to a borrower when a loan officer pushes one of these products in order to meet the qualifying criteria, which are based on the initial payments?
The best case scenario is the client is pressed for cash each month and their standard of living suffers. To avoid further payment increases, they pay several thousand dollars for a refinance to a more suitable mortgage product. In the worst case, foreclosure, financial disaster, and a ruined credit history are the result. I'm not saying this is the case with all Option ARM clients; however, this is a trap many borrowers are falling into.
Option ARMs are not new. They have been on the market for at least 15 years. However, they are exploding in popularity and many borrowers are almost completely unaware of how dangerous they can be.
If a client is selecting the Option ARM because the minimum payment is the limit of what they can afford most months, then THIS IS NOT THE PRODUCT FOR THEM. They need to understand that the amount they owe on their mortgage can exceed the value of their home within a couple of years and that they are putting themselves at risk for dramatic payment increases.
So when should a Pay Option ARM be utilized? It can be a useful tool for commission based employees or business owners who can demonstrate significant financial discipline. It is also useful for people who are looking for inexpensive short term financing; such as those looking to flip properties, stay in one place for a short period of time, or when two incomes become one for a short period of time (i.e. maternity or a husband goes back to school).
These loans are becoming too popular. Instead of being marketed as a double-edged financial tool, too many mortgage companies are aggressively pushing the low payments the minimum option offers without disclosing the hazards. This is predatory.
A better option for people buying at the limit of their budget would be the (still somewhat risky) interest-only loan. At least the interest-only loan will stay fixed for a set period of time, often 5 to 10 years, and there is no danger of negative amortization. Plus, the holder of an interest-only mortgage can always pay extra on any given month, equating his payment to a fully amortized payment for 15 years, 30 years, or any other term.
Like many things, the Option ARM is too good to be true for many (if not most) of the borrowers securing this type of mortgage. However, the Option ARM has much bigger teeth than many other financial mistakes and they can bite quickly and unbelievably painfully.
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