The Benefits of Option ARMS

The main reason nobody has anything good to say about these loans nowadays is because so many average homeowners took them when they’re actually beneficial to only a select group of people. Unfortunately, the way banks and brokers pushed Option ARMs over the past several years gave most of these homeowners the impression that they’re an all-around great loan, when nothing could be further from the truth.

Who Benefits from the Option ARM?

Before we cover the situations in which this type of loan could be beneficial, I should start off by saying that Option ARMs are a niche product, a relatively complicated loan program that can only benefit select groups of people; anyone not part of one of those select groups shouldn’t even consider an Option ARM.

Option ARMs are great loans for the following groups, but only if the conditions are right:

1. Commissioned Workers: Option ARMs offer the borrower the option of making an extremely low minimum payment if need be. Homeowners with salary jobs may not see a huge benefit to this, but homeowners who are paid a large chunk of their incomes in the form of commission may find the minimum payment option quite convenient. As someone who’s worked for 100% commission, I can attest to the fact that income can fluctuate quite a bit from month to month at such a job. One month you may bring in $20,000, the next month $0. When your income fluctuates so much it’s nice to have the option to vary your expenses, something Option ARMs can offer.
2. Real Estate Flippers: Investors who buy a house with the goal of fixing it up and flipping it for a profit need access to as much cash to spend on upgrades as possible. The Option ARM’s minimum payment can help them free up a bit more cash that they wouldn’t have had otherwise. Sure they’re deferring interest, but when you’re making 20-30% profit on every dollar you spend, deferring 7% worth of interest isn’t a big deal. These days, however, Option ARMs are tough to get without making a down payment on the purchase, something many investors prefer not to do.
3. Savvy Investors looking to free up some cash: I say “savvy” because it’s important that the borrower understand how an Option ARM functions and is able to calculate a benefit of investing the extra cash freed up by the minimum payment. This really isn’t the best approach for the average homeowner, not even for the casual investor; you really have to understand the numbers or pay someone who does, because when investments come into play, calculating Option ARM benefits can get pretty hairy. Assuming the investor understands the intricacies involved, he or she may benefit from extra cash afforded by the minimum payment should a great investment opportunity suddenly pop up.

Rate and Prepayment Penalty Determine Benefit

The three groups of people above are certainly great candidates for an Option ARM, but that doesn’t mean its the best loan for all of them all the time. Option ARM interest rates can vary quite a bit and, obviously, the higher the interest rate, the less the benefit for all three groups above. A low rate is absolutely essential with an Option ARM. In spite of what the mainstream media says, you can get an Option ARM at a descent interest rate, but the main reason brokers have pushed Option ARMs in the past is because they pay out major points in the form of YSP (a rebate paid by the bank to the broker). However, this huge rebate (usually around 3 pts, or 3% of the loan amount) requires a higher interest rate and longer prepayment term. Since many homeowners in Option ARMs today only got them because of the low minimum payment, the actual interest rate was usually overlooked, so brokers could get away with hiking the rate up to 9% or so to get a bigger rebate.

Also, an Option ARM with no prepayment penalty doesn’t pay nearly the rebate on the same loan with a 3 year prepayment penalty, and again since borrowers, in the past, were usually focused on the mouth watering minimum payment, brokers could get away with throwing on a 3-year prepayment penalty. I’ve seen Option ARMs put $30,000+ into the brokers pocket before he’s even charged the borrower a dime, but only with a 2+ year prepayment penalty and a high interest rate.

These days, a low risk borrower can get an Option ARM rate as low as 6.5% or so and no prepayment penalty, which is very comparable to 30-year fixed rates, but with greater flexibility when used correctly.

The Option ARM spread like the plague when it was first introduced around 2001, but it’s really a specialized, niche product that requires a complete understanding of it’s inner workings to prove beneficial. If you think you may benefit from an Option ARM, or you just want to learn a bit more about the inner workings, our next article will cover some of the terms all homeowners should understand when considering an Option ARM.