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Adjustable Rate Mortgages with Flexible Payments

19 January 2004, Revised 15 February 2005, 1 August 2005, 11 March 2009

Flexible payment ARMs carry a variety of names in the marketplace: "1 Month Option Arm", "12 MTA Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan", and "Pay Option ARM". All refer to an adjustable rate mortgage on which the rate adjusts monthly with no adjustment caps, and that allows (but does not compel) borrowers to make very low initial mortgage payments that rise over time.

Most commonly, they are referred to as "option ARMs", and I will use that term here.

Their major drawback is that those who select the minimum payment option may suffer "payment shock" – a sudden and sharp increase in the payment for which they are not prepared.

Option ARMs are also very complicated, which creates a danger that borrowers will take them without fully understanding the risks. Borrowers who don’t understand option ARMs, furthermore, may overpay, which increases the risk of payment shock.

The main selling point of option ARMs is the low payment in the early years. This allows borrowers to buy more costly houses, or use the monthly payment savings to pay down other high-cost debt, make home improvements, invest in the stock market, and on and on. Loan officers and mortgage brokers selling option ARMs have long lists of ways to use the cash flow savings. They may provide little information, however, about how they work and what the risks are.

The initial interest rate on an option ARM is a "teaser", it can be as low as 1%, but it holds only for the first month. In the second month, the rate jumps to equal the "fully-indexed rate": the most recent value of the index used by the ARM, plus the margin.

Consider a 1% option ARM originated in early February 2005 that uses COFI as its index, and has a 2.75% margin. At the time of origination, the last rate available for COFI was 2.118% for December, 2004. The rate in March will be the value of COFI in January, 2005 plus 2.75%. If COFI does not change between December and January, the new rate will be 2.118% + 2.75% = 4.868%. Since the margin affects the rate in every month but the first, it is much more important to the borrower than the initial rate.

The interest rate on an option ARM adjusts monthly, with no limit on the size of interest rate changes except a maximum rate over the life of the loan. The maximums generally range from 9.95% to 12% or higher. Almost all option ARMs, however, use rate indexes that adjust slowly to market changes. COFI is one such slow-moving index, others are COSI, CODI and MTA.

The minimum initial payment on an Option ARM is calculated at the interest rate in month 1, and rises by 7.5% a year. While the interest rate jumps in month 2, the initial payment holds for the year. In the four years that follow, each minimum is 7.5% higher than the minimum in the preceding year. The rate in month one thus determines the minimum payments for the first 5 years.

However, the rule that the minimum payment rises 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 be fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the 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. After the first month, the minimum payment usually will not cover the interest due and the difference is added to the balance. All option ARMs have negative amortization maximums, which range from 110% to 125% of the original loan balance. If the balance hits the negative amortization maximum, the payment is immediately raised to the fully amortizing level.

Either the recast provision or the negative amortization cap can result in payment shock. For a borrower making the minimum payments, the likelihood of payment shock is larger the greater is the rise in the interest rate index; the larger is the margin; and the lower the rate in month one that established the minimum payment.

Borrowers and lenders have no control over changes in the interest rate index, but the margin and the interest rate in month one are set in the contract.

In assessing the risk of payment shock, I looked at how payments would change on a 30-year ARM that used the COFI index with a value of 2.118% at the beginning. (This was the value of COFI for December 2004). Two interest rate scenarios were used: one kept COFI unchanged at 2.118%, the second had it increase by 1% a year for 5 years to 7.118%. I used start rates of 1.25%, 1.95% and 2.95%, and margins of 2%, 2.75% and 4%. The calculations were done using my Calculator 7ci. The results are in Tables 1-3 below.

Table 1 shows that even with a stable interest rate scenario, borrowers who took the lowest start rate or paid the highest margin were heavily exposed. A borrower with the lowest start rate of 1.25% and the highest margin of 4% would face a payment increase of 58.5% in month 61. Raising the start rate to 1.95% and 2.95% while keeping the margin at 4% would reduce the increase to 40.4% and 18.3%, respectively.

Lenders should not be offering combinations that result in payment shock in a stable rate scenario. Start rates of 1.25% should be limited to borrowers who command a margin of 2%, while borrowers who pay 4% or more should receive start rates no lower than 2.95%.

Any realistic assessment of payment shock exposure must consider the possibility that interest rates will increase. The scenario I used, a 1% increase a year for 5 years, is not trivial, yet it is very far from being a "worst case."

The results shown in Table 2 are scary. Under the best possible outcome, using the highest start rate of 2.95% and the lowest margin of 2%, the borrower would be hit with a payment increase of 58.0% in month 61. At the lowest start rate and the largest margin, the payment would jump by 175.7% in month 61! Other results fell between these limits.

A lender who read the early version of this article wrote me to say that his option ARM did not recast for 10 years. The implication was that this reduces the potential for payment shock. To test this, I repeated the rising rate scenario just as before but with a recast of 10 years rather than 5. The results are in Table 3.

Comparing the results in Table 3 with those in Table 2, the longer recast does reduce the payment shock significantly, but only if the start rate is not too low and the margin too high. Consider the most favorable case, with a start rate of 2.95% and a margin of 2%. The 5-year recast in this case resulted in a payment increase of 58% in month 61 following 4 years of 7.5% increases. The 10-year recast resulted in a payment increase of 27% in month 121 following 9 years of 7.5% increases.

In unfavorable cases, the differences are smaller because the negative amortization cap kicks in before the 10 years is over. Consider the least favorable case, with a start rate of 1.25% and a margin of 4%. The 5-year recast in this case resulted in a payment increase of 176% in month 61 following 4 years of 7.5% increases. The 10-year recast resulted in a payment increase of 160% in month 63, just two months later. The balance hit the negative amortization cap of 125% in that month, making the longer recast period largely irrelevant.

Don’t be dazzled by a low initial rate, it holds only for one month. Your major focus should be on the margin, because that is what determines your rate in the remaining 359 months. Your second priority should be the maximum rate. Your third priority should be total lender fees paid upfront.

The critical role of the first month rate is that it determines your payment for the first year, and for all subsequent years until you either reach a recast point or a negative amortization cap. The lower the initial payment, the greater your exposure to future payment shock. Hence, you should select the highest rate that results in a payment with which you are comfortable.

Option ARMs are relatively easy to shop. Since the rate holds only for one month, lenders don’t reprice them every day with changes in the market, as they do with other mortgages. You can therefore afford to be deliberate and take your time. You don’t have to worry about getting a rate lock, but you should get the margin, maximum rate and fees on paper.

Consumer protection zealots would ban option ARMs because of their risks to naive borrowers who don't know what they are getting themselves into. I think that is unnecessary because an adequate disclosure can make these hazards very clear, without eliminating what is a useful option to some borrowers. Here is a sample disclosure, with the bracketed information specific to the individual loan.

Your initial minimum payment of [$321.64] is calculated at 1% and holds for one year. The minimum payment is increased by [7.5%] for [5] consecutive years, but may increase more – see below.

The minimum payment does not cover the interest, with the result that your loan balance will increase over time. This is called “negative amortization”.

The initial interest rate of [1%] holds only for [December, 2008]. The rate in month 2 and all subsequent months will equal the most recent monthly value of the rate index [one-year LIBOR], plus a fixed margin of [3.00%].

The index as of [November, 2008] was [2.00%]. If the index does not change, the interest rate will rise to [5% in January, 2009] and remain there. In this case, assuming you make only the minimum payment, the payment will rise to [$429.54 in year 4]. Because the payment must become fully-amortizing after 5 years, in month 61 it will increase by [40% to $600.28].

The maximum interest rate on this loan is [10%]. If the rate jumps to the maximum in month 2, a “worst case”, and assuming you make the minimum payment every month, the balance will reach the maximum negative amortization cap of [115%] in month [29]. This will require that the payment be increased by [276%, from $371.70 in month 29 to the fully-amortizing level of $1025.70 in month 30.]

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 61, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Stable at 2.118%,

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 61, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Rises by 1%/Year, From 2.118% to 7.118%, Over 5 Years

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 121, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Rises by 1%/Year, From 2.118% to 7.118%, Over 5 Years

Note. R means that the last payment increase was the result of recast, N means it was the result of the negative amortization cap.

Flexible payment ARMs carry a variety of names in the marketplace: "1 Month Option Arm", "12 MTA Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan", and "Pay Option ARM". All refer to an adjustable rate mortgage on which the rate adjusts monthly with no adjustment caps, and that allows (but does not compel) borrowers to make very low initial mortgage payments that rise over time.

Most commonly, they are referred to as "option ARMs", and I will use that term here.

Pros and Cons of Option ARMs

Their major drawback is that those who select the minimum payment option may suffer "payment shock" – a sudden and sharp increase in the payment for which they are not prepared.

Option ARMs are also very complicated, which creates a danger that borrowers will take them without fully understanding the risks. Borrowers who don’t understand option ARMs, furthermore, may overpay, which increases the risk of payment shock.

The main selling point of option ARMs is the low payment in the early years. This allows borrowers to buy more costly houses, or use the monthly payment savings to pay down other high-cost debt, make home improvements, invest in the stock market, and on and on. Loan officers and mortgage brokers selling option ARMs have long lists of ways to use the cash flow savings. They may provide little information, however, about how they work and what the risks are.

Rate Changes on an Option ARM

The initial interest rate on an option ARM is a "teaser", it can be as low as 1%, but it holds only for the first month. In the second month, the rate jumps to equal the "fully-indexed rate": the most recent value of the index used by the ARM, plus the margin.

Consider a 1% option ARM originated in early February 2005 that uses COFI as its index, and has a 2.75% margin. At the time of origination, the last rate available for COFI was 2.118% for December, 2004. The rate in March will be the value of COFI in January, 2005 plus 2.75%. If COFI does not change between December and January, the new rate will be 2.118% + 2.75% = 4.868%. Since the margin affects the rate in every month but the first, it is much more important to the borrower than the initial rate.

The interest rate on an option ARM adjusts monthly, with no limit on the size of interest rate changes except a maximum rate over the life of the loan. The maximums generally range from 9.95% to 12% or higher. Almost all option ARMs, however, use rate indexes that adjust slowly to market changes. COFI is one such slow-moving index, others are COSI, CODI and MTA.

Payment Changes on an Option ARM

The minimum initial payment on an Option ARM is calculated at the interest rate in month 1, and rises by 7.5% a year. While the interest rate jumps in month 2, the initial payment holds for the year. In the four years that follow, each minimum is 7.5% higher than the minimum in the preceding year. The rate in month one thus determines the minimum payments for the first 5 years.

However, the rule that the minimum payment rises 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 be fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the 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. After the first month, the minimum payment usually will not cover the interest due and the difference is added to the balance. All option ARMs have negative amortization maximums, which range from 110% to 125% of the original loan balance. If the balance hits the negative amortization maximum, the payment is immediately raised to the fully amortizing level.

Either the recast provision or the negative amortization cap can result in payment shock. For a borrower making the minimum payments, the likelihood of payment shock is larger the greater is the rise in the interest rate index; the larger is the margin; and the lower the rate in month one that established the minimum payment.

Borrowers and lenders have no control over changes in the interest rate index, but the margin and the interest rate in month one are set in the contract.

Measuring Payment Shock on an Option ARM

In assessing the risk of payment shock, I looked at how payments would change on a 30-year ARM that used the COFI index with a value of 2.118% at the beginning. (This was the value of COFI for December 2004). Two interest rate scenarios were used: one kept COFI unchanged at 2.118%, the second had it increase by 1% a year for 5 years to 7.118%. I used start rates of 1.25%, 1.95% and 2.95%, and margins of 2%, 2.75% and 4%. The calculations were done using my Calculator 7ci. The results are in Tables 1-3 below.

Table 1 shows that even with a stable interest rate scenario, borrowers who took the lowest start rate or paid the highest margin were heavily exposed. A borrower with the lowest start rate of 1.25% and the highest margin of 4% would face a payment increase of 58.5% in month 61. Raising the start rate to 1.95% and 2.95% while keeping the margin at 4% would reduce the increase to 40.4% and 18.3%, respectively.

Lenders should not be offering combinations that result in payment shock in a stable rate scenario. Start rates of 1.25% should be limited to borrowers who command a margin of 2%, while borrowers who pay 4% or more should receive start rates no lower than 2.95%.

Any realistic assessment of payment shock exposure must consider the possibility that interest rates will increase. The scenario I used, a 1% increase a year for 5 years, is not trivial, yet it is very far from being a "worst case."

The results shown in Table 2 are scary. Under the best possible outcome, using the highest start rate of 2.95% and the lowest margin of 2%, the borrower would be hit with a payment increase of 58.0% in month 61. At the lowest start rate and the largest margin, the payment would jump by 175.7% in month 61! Other results fell between these limits.

Does a Longer Recast Period Help?

A lender who read the early version of this article wrote me to say that his option ARM did not recast for 10 years. The implication was that this reduces the potential for payment shock. To test this, I repeated the rising rate scenario just as before but with a recast of 10 years rather than 5. The results are in Table 3.

Comparing the results in Table 3 with those in Table 2, the longer recast does reduce the payment shock significantly, but only if the start rate is not too low and the margin too high. Consider the most favorable case, with a start rate of 2.95% and a margin of 2%. The 5-year recast in this case resulted in a payment increase of 58% in month 61 following 4 years of 7.5% increases. The 10-year recast resulted in a payment increase of 27% in month 121 following 9 years of 7.5% increases.

In unfavorable cases, the differences are smaller because the negative amortization cap kicks in before the 10 years is over. Consider the least favorable case, with a start rate of 1.25% and a margin of 4%. The 5-year recast in this case resulted in a payment increase of 176% in month 61 following 4 years of 7.5% increases. The 10-year recast resulted in a payment increase of 160% in month 63, just two months later. The balance hit the negative amortization cap of 125% in that month, making the longer recast period largely irrelevant.

Advice to Shoppers

Don’t be dazzled by a low initial rate, it holds only for one month. Your major focus should be on the margin, because that is what determines your rate in the remaining 359 months. Your second priority should be the maximum rate. Your third priority should be total lender fees paid upfront.

The critical role of the first month rate is that it determines your payment for the first year, and for all subsequent years until you either reach a recast point or a negative amortization cap. The lower the initial payment, the greater your exposure to future payment shock. Hence, you should select the highest rate that results in a payment with which you are comfortable.

Option ARMs are relatively easy to shop. Since the rate holds only for one month, lenders don’t reprice them every day with changes in the market, as they do with other mortgages. You can therefore afford to be deliberate and take your time. You don’t have to worry about getting a rate lock, but you should get the margin, maximum rate and fees on paper.

Mandatory Disclosures of the Hazards of Option ARMs

Consumer protection zealots would ban option ARMs because of their risks to naive borrowers who don't know what they are getting themselves into. I think that is unnecessary because an adequate disclosure can make these hazards very clear, without eliminating what is a useful option to some borrowers. Here is a sample disclosure, with the bracketed information specific to the individual loan.

Your initial minimum payment of [$321.64] is calculated at 1% and holds for one year. The minimum payment is increased by [7.5%] for [5] consecutive years, but may increase more – see below.

The minimum payment does not cover the interest, with the result that your loan balance will increase over time. This is called “negative amortization”.

The initial interest rate of [1%] holds only for [December, 2008]. The rate in month 2 and all subsequent months will equal the most recent monthly value of the rate index [one-year LIBOR], plus a fixed margin of [3.00%].

The index as of [November, 2008] was [2.00%]. If the index does not change, the interest rate will rise to [5% in January, 2009] and remain there. In this case, assuming you make only the minimum payment, the payment will rise to [$429.54 in year 4]. Because the payment must become fully-amortizing after 5 years, in month 61 it will increase by [40% to $600.28].

The maximum interest rate on this loan is [10%]. If the rate jumps to the maximum in month 2, a “worst case”, and assuming you make the minimum payment every month, the balance will reach the maximum negative amortization cap of [115%] in month [29]. This will require that the payment be increased by [276%, from $371.70 in month 29 to the fully-amortizing level of $1025.70 in month 30.]

Table 1

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 61, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Stable at 2.118%,

Initial Payment | Maximum Payment | Number of 7.5% Increases | Last Payment Increase | Month of Last Increase | |

Start Rate 1.25 % | |||||

Margin 2% | $333.26 | $518.00 | 4 | 16.4% | 61 |

Margin 2.75% | $333.26 | $583.02 | 4 | 31.0% | 61 |

Margin 4% | $333.26 | $705.46 | 4 | 58.5% | 61 |

Start Rate 1.95% | |||||

Margin 2% | $367.13 | $504.49 | 4 | 2.9% | 61 |

Margin 2.75% | $367.13 | $568.17 | 4 | 15.9% | 61 |

Margin 4% | $367.13 | $688.19 | 4 | 40.4% | 61 |

Start Rate 2.95% | |||||

Margin 2% | $418.92 | $490.35 | 2 | 1.3% | 37 |

Margin 2.75% | $418.92 | $546.35 | 3 | 5.0% | 49 |

Margin 4% | $418.92 | $661.74 | 4 | 18.3% | 61 |

Table 2

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 61, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Rises by 1%/Year, From 2.118% to 7.118%, Over 5 Years

Initial Payment | Maximum Payment | Number of 7.5% Increases | Last Payment Increase | Month of Last Increase | |

Start Rate 1.25 % | |||||

Margin 2% | $333.26 | $942.66 | 4 | 111.8% | 61 |

Margin 2.75% | $333.26 | $1042.72 | 4 | 134.3% | 61 |

Margin 4% | $333.26 | $1227.19 | 4 | 175.7% | 61 |

Start Rate 1.95% | |||||

Margin 2% | $367.13 | $919.42 | 4 | 87.5% | 61 |

Margin 2.75% | $367.13 | $1017.61 | 4 | 107.6% | 61 |

Margin 4% | $367.13 | $1198.76 | 4 | 144.5% | 61 |

Start Rate 2.95% | |||||

Margin 2% | $418.92 | $883.82 | 4 | 58.0% | 61 |

Margin 2.75% | $418.92 | $979.14 | 4 | 75.0% | 61 |

Margin 4% | $418.92 | $1155.19 | 4 | 106.5% | 61 |

Table 3

Payment Changes on a $100,000 30-Year Option ARM With Recast in Month 121, Negative Amortization Cap of 125%, at Different Start Rates and Margins

Scenario: COFI Rises by 1%/Year, From 2.118% to 7.118%, Over 5 Years

Initial Payment | Maximum Payment | Number of 7.5% Increases | Last Payment Increase | Month of Last Increase | |

Start Rate 1.25 % | |||||

Margin 2% | $333.26 | $1102.80 | 8 | 99.5% | 98(N) |

Margin 2.75% | $333.26 | $1145.94 | 6 | 122.8% | 80(N) |

Margin 4% | $333.26 | $1242.09 | 5 | 159.6% | 63(N) |

Start Rate 1.95% | |||||

Margin 2% | $367.13 | $1135.74 | 9 | 61.4% | 121(R) |

Margin 2.75% | $367.13 | $1156.53 | 7 | 89.9% | 90(R) |

Margin 4% | $367.13 | $1246.77 | 5 | 136.6% | 68(N) |

Start Rate 2.95% | |||||

Margin 2% | $418.92 | $1017.19 | 9 | 26.6% | 121(R) |

Margin 2.75% | $418.92 | $1193.38 | 9 | 48.6% | 121(R) |

Margin 4% | $418.92 | $1254.34 | 6 | 94.0% | 78(N) |

Note. R means that the last payment increase was the result of recast, N means it was the result of the negative amortization cap.