How does it work?
An option ARM is an adjustable-rate mortgage with a twist. You don’t pay a set amount each month. Instead, the lender sends a monthly statement with up to four payment options. You simply choose the amount you want to pay that month and then submit your payment.
The options vary, but here’s the most common menu:
Minimum payment: This is calculated using an “initial” interest rate that can start as low as 1.25 percent. Because this payment is so low, it’s useful for months when you don’t have much cash on hand, perhaps because you are waiting for a commission or bonus check. But any unpaid interest gets deferred, or added to the principal of the loan, so your principal grows.
Interest only: You pay all the interest due, but none of the principal. This doesn’t reduce your mortgage balance, but it allows you to avoid deferring interest.
30-year amortized: This matches the monthly payment of a mortgage amortized over 30 years at your current interest rate. It includes both principal and interest.
15-year amortized: The same as above, but amortized over 15 years. This is the highest monthly payment. Choosing it allows you to reduce your principal faster than any other option.
The fine print
The biggest caveat with option ARMs is that those enticing initial rates are short-lived. The low minimum payments that make these mortgages so attractive can increase dramatically. In addition, every five years, the loan is recast -- that is, a new amortization schedule is drawn up to ensure that the remaining balance will be paid off by the end of the loan’s term. When that happens, the minimum payment can be pushed even higher.
What’s more, if you defer too much interest, you can reach what’s called negative amortization. If your balance grows to 10 percent to 25 percent (depending on state law) greater than the original principal, your loan is automatically recast and you have to start paying the fully amortized rate, which will increase your monthly payments.
Another potential downside of option ARMs is that they’re more complicated than most other mortgages. Home buyers may be seduced without fully understanding how much the minimum payments will increase over the long-term. When the monthly amounts go up, these people can experience payment shock.
To learn more about flexible payment mortgages, visit http://www.lendingtree.com/cec/yourhome/yourmortgage/open-arms.asp
About the Author:
The editorial staff at LendingTree is committed to helping consumers become smarter borrowers. Visit http://www.lendingtree.com/cec for more information and tips on buying, selling, and financing a home. Copyright 1998-2006, LendingTree, LLC.
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