Option adjustable rate mortgages (ARMs) give would-be homeowners a way to purchase a big house with only a small payment. They also give current homeowners a way to reduce their mortgage payments. While these benefits may seem to be just what the doctor ordered following years of rising prices in an overheated housing market, BusinessWeek magazine has labeled option ARMs "Nightmare Mortgages." In the September 2006 article that sported that name, BusinessWeek stated that the option adjustable rate mortgage might be "the riskiest and most complicated home-loan product ever created."

The truth about whether option ARMs are a useful tool or a ticket to trouble is largely a matter of personal perspective. A closer look at these controversial loans will make it easier to determine their prospective uses - and the risks involved. (To read more about ARMs, see ARMed And Dangerous, Mortgages: Fixed-Rate Versus Adjustable-Rate and Paying Off Your Mortgage.)

The Options
Unlike most mortgages, which come with a set monthly payment, option ARMs, provide a choice each month. (For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

Homeowners can select from the following payments:

  • Minimum
    The minimum required payment for an option ARM is extremely attractive because it is so low. In fact, it's so low that it doesn't even cover the interest on the mortgage. By making the minimum payment, borrowers are in a position known as negative amortization, which means that they owe more on the house at the end of the month than they did at the beginning. While making the minimum payment may not seem to be a wise choice from a financial perspective, it is the most popular option in some high-priced zip codes where homeowners could not otherwise afford to purchase a home. (To read more about negative amortization, see What is the best way to pay off my mortgage?)

    Of course, the small payments don't last forever. Five years after the loan begins, or once the outstanding balance increases to 110% of the initial loan amount, most option ARMs recalculate to determine the fully-amortized payment, which is the payment that would be required to pay off the home over the remaining life of the loan. For most loans, that new number then becomes the minimum required payment and the negative amortization payment is no longer permitted. When this occurs, the amount of the monthly payment can increase substantially, even doubling in size.

  • Interest-Only
    Moving up the scale, this payment costs more than the minimum and does cover the interest, although it does not reduce the principal. The borrower makes no progress toward owning the home, but does avoid negative amortization.
  • 30-Year Amortization
    This is the traditional mortgage payment with which most people are familiar. Making this payment covers the interest and reduces the principal.
  • 15-Year Amortization
    A 15-year loan enables borrowers to pay off their homes more quickly than the traditional 30-year loan. Making this payment covers the interest and reduces the principal.

(To calculate how much time you will need to pay off your home, see our Monthly Mortgage Payment Calculator.)

The Details
The interest rate on most option ARMs changes monthly, and the loans have a cap on the amount the rate can rise each year. Although the actual required payment changes only once per year, the difference between the first month's interest rate and amount of the yearly adjustment can be in excess of 7%. From a minimum payment perspective, this can be a big change. If the outstanding balance reaches 110% of the original balance, there is no limit to the potential amount of the increase.

Who Should Take the Option?

  • The Rich
    These mortgages were developed as a money management tool for the rich. Wealthy people often earn enormous sums of money, but have unpredictable cash flows. Option ARMs enable them to make small payments until their cash flow increases. Many Wall Street moguls and top sales people, for example, get 50% or more of their yearly income in a single lump-sum bonus check. (To learn more about the income classes, see Losing The Middle Class and Surveying The Employment Report.)
  • The Transient
    People who want to live in a big house and don't plan to stay long can use an option ARM to get the house they want without spending a fortune. Corporate executives that are transferred every few years can use these loans to free up cash for other uses.
  • Those Expecting a Financial Windfall
    People that know they are soon going to experience a significant change in income may also choose an option ARM. If marriage, inheritance, a legal settlement or other source of sudden wealth is on the horizon, an option ARM can be a good way to get the house in advance of getting the cash. (To read more on these subjects, see Refusing An Inheritance and Marriage, Divorce And The Dotted Line.)

Benefits for Lenders
Lenders love option ARMs. Mortgage brokers often receive higher payments to sell them and accounting laws allow lenders to book the maximum payment (30-year) as revenue even if they only get the minimum payment. These phantom revenues are perfectly legal, look good on the books and do wonders for a mortgage broker's stock price. Options ARMs also usually carry a higher cost to refinance, so lenders get paid again when borrowers want out of the loans. While there may seem to be some danger in providing such loans, the mortgages are often sold to investors through such vehicles as mortgage-backed securities, passing the risk on to investors instead of the lenders. (For related reading, see Profit From Mortgage Debt With MBS.)

How to Compare
When considering an option ARM, there are several key points to keep in mind. The first is the amount of time that the introductory interest rate lasts. How high the interest rate can rise and how much the payment can change are also important considerations. Knowing when the loan will be adjusted and the threshold for the negative amortization cap should also be considered.

Dream or Nightmare?
While taking out a mortgage should always be done with caution, taking out an option ARM requires an even higher level of vigilance. For those in a solid financial situation with a solid understanding of the terms and conditions that accompany an option ARM, the loan can be a useful tool. For the unprepared, it can be a one-way ticket to trouble.

To continue reading on this subject, check out Investing In Real Estate and Smart Real Estate Transactions.

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