Called “nightmare mortgages” by Bloomberg Businessweek and a “time bomb” by CBS’s 60 Minutes, option-ARM mortgages are clearly not for the average home buyer. These mortgages, often cited as one of the main reasons for the housing collapse of the early 2000s, also go by the names Pay Option, Pick-A-Payment, and cash flow ARM loans. Read the fine print before signing on the dotted line and consult a knowledgeable third party for advice or you risk finding yourself in a sticky financial situation.
Adjustable Rate Mortgages
Mortgages, or loans secured by a piece of real estate, set out a repayment schedule of principal and interest through a process called amortization. Although lenders may offer repayment schedules from five to 40 years in length, the most common are 15-, 20- and 30-year mortgages. Unlike fixed-rate mortgages where the interest rate remains stable throughout the life of the loan, adjustable-rate mortgages, or ARMs, have a fixed interest rate for a set period of time and then the interest rate may change, or adjust, on a monthly or yearly basis until the loan is paid off. Option ARMs are a type of adjustable-rate mortgage that gives the you up to four repayment options.
Amortizing Payment Options
Two repayment options typically offered with an option ARM are the amortizing payment option and accelerated amortizing payment option. These types of option ARMs are fairly standard adjustable-rate mortgages where the lender applies a portion of each monthly payment towards your principal and the rest towards interest, although the interest can change on a monthly basis. You pay back an accelerated option ARM mortgage in 15 years while you pay back a standard amortizing option mortgage in 30 or 40 years.
Interest-Only Payment Options
With an interest-only ARM, your monthly payments satisfy only the interest accruing on the mortgage for a set period of time, usually five to seven years, with no monies applied towards the original loan balance. At the end of the interest-only period, the lender resets or recasts your loan to accommodate interest and principal repayment.
Deferred Interest Payment Options
A deferred interest ARM, also known as minimum- or limited-payment ARM, is one of the most commonly chosen payment options and is similar to an interest-only ARM but with a little twist. Instead of paying all of the accrued interest in each payment, you only pay a portion of it. The difference between what you owe what you pay is tacked on to your original loan balance in a process known as “negative amortization.” Instead of reducing your loan balance each month, you actually increase the amount of principal.
One of the biggest problems with many option ARMs is the payment shock borrowers experience when the loan is recast and payments skyrocket, or when interest rates suddenly peak. If you have chosen a deferred payment or interest-only option, you can minimize the impact by making additional payments each month towards your principal. These loans are also hypersensitive to even slight changes in the housing market, as a downturn could put many interest-only or deferred payment mortgage-holders in a situation where they owe the lender more than the house is actually worth.
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