If you’ve been following the news at all lately you’ve no doubt heard about the poor state of the real estate and mortgage markets these days. Even though the press tends to exaggerate, both markets are in tough shape right now. Much of what the press is focusing on is the Option ARM Mortgage – ARM is an acronym for Adjustable Rate Mortgage. Option ARMs can be a bit confusing, like so many homeowners are finding out, so let’s clear things up and dig into what this beast known as the Option ARM is and whether or not it should even be thought of as a beast at all.

As previously mentioned, ARM stands for Adjustable Rate Mortgage. So it makes sense that the interest rate on this type of loan is adjustable, but it’s a bit more complicated than that. Let’s come back to this in a minute, in the mean time, what does the Option in Option ARM mean? The reason this mortgage type is known as an Option ARM is because it offers the borrower four different payment options each month; now, there are some Option ARMs offering only three payment options, but by far the majority offer four. We’ll start with the fourth option and work our way backwards to the first, which is the meat and potatoes, so to speak, of the Option ARM.

Payment Option Four – 15 Year Amortization

The fourth payment option is the largest of the four, and covers principal and interest, amortized over 15 years. 15-year amortization means that the payment is large enough that it will pay off the loan in 15 years; so, for instance, a 15 year amortized loan will call for a larger payment than a 30 year amortized loan, which will call for a larger payment than a 40 year amortized loan, and so on.

Payment Option Three – 30 Year Amortization

The same applies here as with option four, the only difference is that this option is amortized over 30 years; in other words, if a borrower were to make this payment consistently, the loan would pay off in 30 years.

Payment Option Two – Interest Only

Option two offers the borrower the opportunity to pay only the interest on the loan. With this option, no principal is paid and the mortgage balance never decreases. This payment will always be lower than the 30 year amortized payment – option three – because the 30 year amortized payment includes interest and principal.

Payment Option One – Minimum Payment

Option one is generally referred to as the minimum payment. Now you may be thinking, “What could be lower than interest only?” The simple answer is nothing; the interest is how the bank gets paid, and it will get paid; it’s just a question of when the bank gets paid. Similar to the way we can say a 30-year mortgage is amortized over 30 years, we can say an Option ARM minimum payment is negatively amortized. What this means is that, instead of the principal balance decreasing as it does on a 30-year amortized loan, the principal balance actually increases.

The reason for this is simple; the minimum payment is less than the interest-only payment, or less than the interest that is actually owed to the bank each month. Should a borrower opt to pay the minimum payment, the remaining interest owed is tacked onto the principal balance. This sounds complicated, but it’s really not…time for a little easy math.

If Suzie Homeowner has an Option ARM with a 30-year amortized payment of, say, $2,000, she might also have an interest-only payment of $1,750. On such an Option ARM, Suzie Homeowner might have a minimum payment around $625. If Suzie opts to make the minimum payment this month of $625, the remaining interest charges will be added to the principal balance; so if the interest charges this month are $1,750, and she pays $625, then $1,125 is added to the principal balance ($1,750 – $625 = $1,125). The interest that is tacked onto the principal is also known as deferred interest, because it doesn’t have to be paid now, but it will have to be paid some time down the road.

So Why Not Just Make The Minimum Payment Forever?

It’d be really nice if you could make the minimum payment forever, but banks set limits on the amount of interest that can be deferred. When one of these limits is reached, the loan recasts, meaning the minimum payment option is taken away, and the monthly payments are recalculated based on the current loan amount at the time of the recast.

Option ARM Recast Limits

The first limit represents the maximum time period before the Option ARM recasts, and is generally set at 60 months, or 5 years; at the end of month 60, no matter what payments the borrower has been making, the loan will recast.

The next limit caps the balance of the mortgage anywhere from 110-120% of the original loan amount. So, if Suzie Homeowner has a $300,000 mortgage and makes the minimum payments, deferring interest in the amount of $1,125 each month, the balance of the mortgage will increase to $330,000, 110% of the original balance, in just under 27 months. If her bank’s cap is 110%, her loan will recast at this point; likewise, if her bank’s cap is 120%, her loan will recast in month 53.

The important thing to note about recast limits is that the loan will recast when the first of any limit is reached. So, if Suzie makes minimum payments some months and interest-only payments other months, even though it may take longer than 60 months to reach her cap of 110-120%, her loan will recast at 60 months because it’s the lesser of the two limits.

The Trouble With Option ARMs

Now that we’ve got an understanding of Option ARMs, let’s go over the major problem with these loans. As mentioned earlier, when the loan recasts, the minimum payment option is taken away and the monthly payment is recalculated so that it will pay off in 30 years. The problem with this is what’s known as payment shock; if a borrower is used to making the minimum payment, and the loan recasts, the new minimum payment is usually interest-only and is, usually, more than double the amount of the old, negatively amortized minimum payment. To add to this, if the balance has gone up, when the new 30-year payment is calculated, it’s going to be more than the old 30-year payment. In cases like these, the minimum payment on an Option ARM can sometimes triple in one month. This obviously comes as a shock to borrowers who don’t completely understand how Option ARMs work, and one more little hiccup could make the situation even worse.

The Prepayment Penalty

Prepayment penalties on Option ARMs generally range from 0 to 3 years. A major problem arises when, because the borrower makes mostly minimum payments, the loan reaches its cap of 110-120% of the original balance before the prepayment penalty expires. In this case the borrower is forced to either pay the prepayment penalty or face triple the monthly minimum payment. Most banks watch out for this nowadays and won’t fund such a loan to begin with, but that wasn’t the case only a year ago.

The “ARM” in Option ARM

As if things weren’t complicated enough, Option ARMs also have an adjustable interest rate. Option ARMs are linked to a given index, such as the LIBOR, MTA, or COFI; these indexes fluctuate with market conditions. When the linked index goes up, the rate of the Option ARM goes up, when the index falls, so does the Option ARMs interest rate. Adjustable rates aren’t necessarily a bad thing, but they do represent a greater risk than fixed rates.

Option ARMs are obviously complicated creatures and need to be dealt with carefully. In spite of all the bad press and potential pitfalls, these loans can be beneficial. The benefits of Option ARMs will be the topic of the next article, so stay tuned.

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