Tutorial on Option ARMs

February 22, 2007, January 8, 2012 Postscript

January 8, 2012 Postscript

Default rates on option ARMs were horrendous after the financial crisis of 2008, and they disappeared from the market. Whether they will return anytime soon remains to be seen.

Here is what you will learn in this tutorial:

  1. What is an option ARM?
  2. How will I know an option ARM when I see it?
  3. What are the advantages of an option ARM?
  4. What are the risks of an option ARM?
  5. How do I protect myself against the risks?
  6. Who should select an option ARM?
  7. Should I shop for an option ARM?

What Is an Option ARM?

It is an ARM on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make. The options include interest-only, and a "minimum" payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed "negative amortization".

How Will I Know an Option ARM When I See One?

Ask the loan provider if the rate adjusts monthly, and if negative amortization is allowed. If the answer to both questions is "yes", you almost certainly have one. Their names are all over the lot and include "1 Month Option Arm", "12 MTA Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan", and "Pay Option ARM".

What Are the Advantages of an Option ARM?

Their main selling point is the low minimum payment in year 1. It is calculated at the interest rate in month 1, which can be as low as 1%, and it rises by only 7.5 % a year for some years.

The low initial payment entices some borrowers into buying more costly houses than would have otherwise, or into using the monthly payment savings for other purposes, including investment. You don’t need a list from me of ways to use the cash flow savings because your loan provider is sure to oblige. What they are less likely to give you is a sense of the risks you will face down the road.

What’s Are the Risks of an Option ARM?

For those electing the minimum payment option, the major risk is "payment shock" – a sudden and sharp increase in the payment for which they are not prepared.

The rule that the minimum payment can rise by no more than 7.5% a year has two exceptions. The first is that every 5 or 10 years the payment must be "recast" to become fully-amortizing. It is raised to the amount that will pay off the loan within the remaining term at the then current interest rate – regardless of how large an increase in payment is required.

The second exception is that the loan balance cannot exceed a negative amortization maximum, which can range from 110% to 125% of the original loan balance. If the balance hits the negative amortization maximum, which can happen before 5 years have elapsed if interest rtes have gone up, the payment is immediately raised to the fully amortizing level.

Either the recast provision or the negative amortization cap can result in serious payment shock.

How Do I Protect Myself Against The Risks?

Three ways:

1. Measure the Risk: You can do this yourself using my calculator 7ci. It will show you what will happen to the payment on your option ARM if interest rates follow any of a number of future scenarios selected by you. An important side benefit is that the calculator lists the information you need, which you want for shopping purposes anyway.

2. Minimize the Risk by Shopping For the Lowest Margin. The margin on your loan is the amount added to the interest rate index to get your rate. Since the margin affects the rate in months 2-360, it is the most critical price variable on an option ARM. The lower the margin, the lower your cost and your vulnerability to payment shock. Note: The margin is not a required disclosure, so don’t expect that it will necessarily be volunteered.

3. Minimize the Risk by Taking the Highest Initial Payment You Can Afford. The higher your initial payment, the smaller the potential payment shock down the road. Since the initial payment is determined by the interest rate in month 1, you should select the highest rate that results in a payment with which you are comfortable. Asking for a higher rate sounds a little strange, but remember, the quoted rate holds only for one month.

Who Should Take an Option ARM?

Choose one if your time horizon is short and you want to maximize your home-buying capacity. Because of their low initial rates and payments, borrowers can usually qualify for a larger loan using an option ARM. Since payments will be substantially higher in later years, you should confidently expect your income to rise in the future. The option ARM is also a refinance option if your income has dropped and the alternative to lower payments is default. I do not advise using this instrument to generate cash flow savings to invest, see Is Unused Home Equity a Missed Fortune?

Should I Shop For An Option ARM?

Yes, emphatically, but not for the rate. Your major focus should be on the margin, because that is what determines your rate after the first month. Your second priority should be the maximum rate. Your third priority should be total lender fees.

The good news about monthly ARMs is that lenders don’t reprice them every day as they do other mortgages, which makes comparison shopping much easier. You don’t need a rate lock, but ask the loan provider to specify the margin, maximum rate and fees on paper.

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