Are Option ARMs an Option?

The Options Adjustable Rate Mortgage is an Adjustable Rate Mortgage (ARM) and like most ARMs it consists of taking an index, most commonly the MTA (12 month Treasury Average), CODI (Cost of Deposit Index), and COSI (Cost of Savings Index), then adding a margin to total the final interest rate.

Unlike other traditional mortgages, where the payment is calculated from the total of the index and margin, the Options ARM offers 4 monthly payment options every month, giving you the opportunity to choose which payment to make. This monthly payment option is where the Options ARM derives its name. The typical four payment choices are:

THE MINIMUM PAYMENT OPTION – This allows you to make a small monthly payment usually equivalent to a 30 year mortgage at 1% interest, or about half of your interest cost for the month. This unpaid interest expense increases the principle balance of the mortgage.

INTEREST ONLY PAYMENT – This covers all of the cost of the interest for the month. Choosing this keeps the mortgage balance from increasing or decreasing.

30-YEAR PAYMENT – Standard principle and interest payment that will pay the loan off in 30 years

15-YEAR PAYMENT – Standard principle and interest payment that will pay the loan off in 15 years

Now that we have define the Option ARM, we need to answer the questions, “Is it an option (pun intended) for me?” As with most things in life, there are positives and negatives.
Lets start with the good news. Option ARMs exist because there is market for them. They do some things better than other mortgage types. For example:

Low payment – there is no mortgage option that give a lower payment on a given principle balance. If you choose the lowest monthly payment you are not even required to cover the cost of the money. Clearly, the downside of this will be discussed later, but if, for a variety of reasons, you need a low, low payment, an option ARM cannot be beat.

Automatic payment adjustment – Though not unique to option ARMs, having the payment automatically decrease with a principle payment can come in handy. For example, you finally sold your old house and want to use that equity to lower the amount of money you owe on your new house. When you make that large principle payment, your monthly payment will automatically drop accordingly. You do not need to refinance and pay loan and title fees to take advantage of your new lower balance.

High loan amounts available – In our current credit climate, many of the ALT-A products that used to exist are gone. The lenders that offer the option ARMs tend to be some of the few remaining sources that will give higher loan amounts, higher LTVs, and lower required documentation for their loans. If the traditional mortgage cannot get approved—-and you really need the loan—the option ARM may work.

Of course, we cannot forgo the negatives, and frankly, with the option ARM there are (numerically) many more negatives than positives. However, you should consider the risk of the negatives and weigh them against the gains before rejecting the option ARMs outright.

High cost of money – If you qualify for a traditional mortgage and are considering an option ARM, you should understand that the flexibility comes at a price. Everything else being equal, the interest rate on an option ARM is almost always higher. Sometime times this difference is miniscule, but sometimes it can be 3 or 4 percent higher. On a $300,000 loan, a 4% higher rate costs you $1000 MORE per month in interest. Be sure to compare the fully indexed rate against other mortgage choices prior to signing the paperwork.

Negative Amortization (Neg Am)- This means that rather than amortizing your mortgage over 30 years and paying the principle to zero in that time, you are actually increasing the balance owed each month you make only the minimum payment. The ramifications of Neg Am can be very costly.

Banks are smart. They do not allow you to have a Neg. Am. loan forever. At a certain point your loan will recast. This means that you have exceeded the original principle balance by a contractual percentage. For example, many Option ARMs recast at 110% of the original balance. Once you have reached this mark, your new minimum monthly payment is often the fully amortized 30 year principle and interest payment. This can cause a payment to increase 3 or 4 times the minimum all at once. This can be an unwelcome event if you were accustom to only paying the lowest payment.

This much higher principle balance causes another problem. It is almost impossible to refinance out of this loan, since in our current market you typically owe substantially more than the home is worth. This leaves many borrowers two choices; foreclosure or struggle with the new payment. This is a very ugly outcome.

HELOC – It can be difficult to borrow additional money against a property that has an Option ARM as a first mortgage. Many home equity lenders flat out refuse to be in 2nd position behind a 1st mortgage that can increase in size over time and erode their collateral position. Though this is not a fatal flaw it is worth noting.

Monthly rate adjustments – Many Option ARMs have a provision for monthly unlimited interest rate adjustment. In a declining rate environment, such as we are currently experiencing, this can be a good thing. However, as rates begin to rise again, they will likely rise quickly and this will cause your cost of money to skyrocket. Many Option ARMs do not have a cap on how much or how high they can rise. This uncertainty can become very expensive and can cause a loan to recast unexpectedly. Some lenders have modified this to have an initial interest rate that is locked for 5 years, but they are not all this way.

Enough of the pros and cons. Why do these exist? Who should use this product? In my opinion, this product should be used in two instances. The first group of borrowers that should consider this product are borrowers that have irregular income. For instance, you receive a nominal salary weekly and a substantial annual bonus. This borrower should use the low monthly payment option monthly and use discipline to pay down the accrued interest with a portion of the large annual check. In this instance, the Option ARM helps with monthly cash flow, but many of the negatives are not a factor.

The second group of borrowers that will benefit from an Option ARM are the borrowers with transitory circumstances. Examples of these circumstances are as follows:
Buying a new home without selling your old home. In this real estate market, many borrowers are looking to take advantage of depressed prices and move up to a large home at a great price, but they are unwilling to sell their existing home. By using an Option ARM until the market turns around, a borrower can afford to wait to sell their old home and still take advantage of a great price on a new one.

Job changes or temporary income gaps. When a family relocates due to a job change and the other spouse is now job hunting in a new area, an Option ARM can allow the family to buy a house and afford the payment until the second spouse finds a job.
Debt management can be another transitory event that takes advantage of a low mortgage rate. For example, a family that has $20,000 in credit card debt at 24% interest would be able to make only the minimum payment on the house and use the balance of the payment to aggressively pay down higher cost debt. Of course, once the debt is paid off, they should resume paying at least the interest only payment.

Finally, a word of caution, Option ARMs can be complicated and sophisticated financial tools. Do not be sucked into the low initial payment to buy a home beyond your means. If you live on a regular or fixed income, you are guaranteeing problems for your future if you use this tool in an unwise manner. Be sure you are receiving good advice from your mortgage professional. Make sure you understand and appropriately weigh the pros and cons. You are always welcome to call us to discuss this and any other mortgage topic. We lend nationwide and are happy to discuss all of your options with you.