Beware of Option ARM (Adjustible Rate Mortgages)

There is a new but very dangerous player in the mortgage industry; it is called Option Adjustible Rate Mortgage (ARM). This is a very complex loan that if not understood properly, could ultimately cost you your home! Option ARM is a type of mortgage plan with as many as 4 different monthly payments and an interest rate that could fluctuate month to month!

Every month when it comes time to make that mortgage payment, the borrower can choose his payment to be one of four types:

The goal of Option ARMs is to minimize the monthly payment and get it as low as possible. Some loans even deceive people by advertising "1% mortgage loans" where the actual interest rate is 6%, except that the unpaid 5% portion is added to the original debt of the borrower, thus increasing his debt. You would think that with every monthly payment you make, you are working towards paying your mortgage off... Wrong! Infact, you are only increasing the size of your mortgage loan, and getting more into debt!

The reason behind creating option ARMs was to help the first time home buyer be able to afford the monthly payments on ever increasing house prices in the US. Since most first time home buyers do not have a lot of money to put down towards the house, they are turning towards Option ARMs to help them.

Fact: Less than one in every 100 borrowers took out an option ARM in 2003; more than 13 in every 100 borrowers did so in 2006 (Source: LoanPerformance, a company that follows lending trends in the mortgage industry).

Option ARMs attract borrowers who do not even have 1% - 2% of the original value of the house. These borrowers are then promised a monthly payment that is so low; no other mortgage product can compete with this. But as the saying goes, if it sounds too good to be true, it probably isn't. Here's how borrowers who take out Option ARMs could quickly get into financial jeopardy:

- Interest rates go up immediately; making their monthly payments even more expensive. Traditional ARMs fix interest rates for the first 1 to 7 years, after which they are reset once every year. With Option ARMs, the interest rates are reset every month!

- Since borrowers are only to make the minimum monthly payments, or are even allowed to skip some mortgage payments, they will be adding hundreds or even thousands of dollars of debt to their original balance owing. Thus, while most people would expect their homes to be fully paid off in 10 - 20 years, these Option ARM borrowers will have probably doubled or tripled their mortgage loans in 10 - 20 years! This is a financial disaster and should be avoided at all costs!

Here is when it gets even more interesting. If your mortgage loan reaches 110% of what you originally borrowed, the minimum interest payments only clause dissappears and you have to make the full monthly payment where it is applied to all the interset and part of the original principal balance every month. If you get to that level and would like to refinance, most option ARMs will impose penalties of $10,000 or more if you pay them off too early, or refinance them.

For example, lets compare a $100,000 mortgage loan with 5% interest under 2 different mortgage types:

i) 30 year conventional fixed term:

$100,000 x 5% = $5000 per year
$5000 per year interest / 12 months = $417 per month

For that month, you would send the lender $650 out of which $417 will cover the interest portion and $650 - $417 = $233 would go towards the principal. After that 1 month, here's how you would stand:

($100,000 - $233) x 5% = $4987 per year
$4987 per year interest / 12 months = $415 per month

Every month where you make payments, the original mortgage loan is reduced. This is a normal way to get started in your mortgage term.

ii) Interest Only Option ARM @ 5%

$100,000 x 5% = $5000 per year
$5000 per year interest / 12 months = $417 per month

For that month, you would send the lender a check for $417. This would cover only the interest portion, which means you still owe the lender $100,000 (you haven't built any equity in your home). Consider the fact that your interest rate could also increase every month, forcing you to make interest payments of more than $417 per month.

Lets look at a scenario where one month you only have $117 to pay towards the interest. You are therefore skipping an interest charge of $300 that will get added to the original $100,000 balance. Here's how it works:

($100,000 + $300) x 5% = $5015 per year
$5015 per year interest / 12 months = $418 per month

Your interest payment increased from $417 to $418 per month. Doesn't sound like much? This is because you skipped only 1 interst payment, imagine if you skipped 10 interest payments for $300:

($100,000 + $3000) x 5% = $5150 per year
$5150 per year interest / 12 months = $430 per month

You get the idea from here? The more time you make only minimum interest payments, and the more interest-only payments you skip, the larger your debt grows.

Summary

With Option ARMs, you would end up owing a much larger mortgage loan balance to your lender than you had originally borrowed. Also with rising interest rates, your monthly payments would get more expensive on a home that you haven't build any equity in. And if you cannot afford to make those ever increasing interest-only monthly payments, you risk losing your home! Our advice to you is, stay away from Option ARMs!