Option ARMS are mortgage loans with the flexibility of choosing how your payments are structured. This “twist” combines the lower introductory interest rate with the ability to pick your payment amount. These loans feature a minimum payment amount that could be as low as one percent, an interest only payment, a payment based on thirty year amortization, and a payment based 15 year amortization.
Option loans offer a great amount of flexibility for homeowners; however, there are risks for those that abuse the minimum payment amount. The interest rate on your option Adjustable Rate Mortgage is based on the index your loan is tied to and the lender’s margin. Margin is the amount your lender marks up the index when adjusting your payment amount. The margin is based on your credit and financial details; the less margin, the lower your payments will be after each adjustment. If you hear the term “fully indexed rate” this is referring to the current value of the index plus the margin.
The dangers from an Option Adjustable Rate Mortgage come for homeowners that abuse the minimum payment amount. This minimum payment does not cover the amount due in a given month; the unpaid amount is added to the loan principle, a phenomenon known as “negative amortization.” This term means that instead of paying your loan balance down over time your mortgage loan is actually growing. This is unfavorable condition that could lead to your lender recasting the loan as a standard Adjustable Rate Mortgage amortized for the remaining loan term. This happens automatically when your loan reaches $125% of the original loan balance.
Many homeowners experience payment shock when this happens because they are unprepared for the significantly higher monthly payment. This danger has led to a skyrocketing foreclosure rate among homes purchased with option loans. The dangers don’t mean that option mortgages should be avoided altogether; homeowners who fully understand the risks associated with these loans can leverage Option ARMS to their advantage.