Option ARM Loans

THE OPTION ARM LOAN
by James Robert Deal
Mortgage Broker

The Option ARM loan is also known as the Pick-A-Payment loan or the Cash-Flow loan. Option ARM loans are often vilified by mortgage gurus in the newspapers. Some people who take these loans are often shocked at the way the interest rate and principal balance climb month after month. Option ARM loans are referred to as "equity eaters." Some borrowers are shocked that they have pre-payment penalties and are stuck with the loan for one, two, or three years.

Far too many loan officers fail to discuss the negative aspects of these loans and fail to tell the borrower all his options, including the no-pre-payment penalty option or the fixed interest rate option. Far too many borrowers are too trusting like sheep.

The Option ARM loan is often sold to unsophisticated borrowers without full disclosure. It's often referred to as the "1% loan." People think 1% is the interest rate. No, 1% is the payment rate. The interest rate is typically above 8% and the APR is even higher. The payments are low, but if you pay only the required minimum low payment, the balance on your house will go up every month. And greedy loan officers sometimes tack on 3-year pre-payment penalties. Those scammers can make a $10,000 Yield Spread Premium or Rebate on such loans. This is an obscene amount of money for doing someone a disservice. We refinance people out of option ARM loans all the time.

Despite all the negative propaganda about such loans, provided there is full disclosure and the borrower is sophisticated, there are situations where the option ARM loan is the appropriate choice.

They would be appropriate, for example, for the investor who is well-capitalized and knows what he is doing. They can be done with a 1-year pre-payment penalty or no pre-payment penalty. Take the case of the investor who buys a house with plans to remodel it and sell it in six months or one year. He needs low payments in order to conserve cash. But he knows he will more than recoup the cost of the temporary high interest. In such a case the option ARM is an excellent loan. The point is that you have to match the right loan with the right person.

There are many versions of the Option ARM loan. All of them have a very low minimum required payment option that is so low it does not fully pay interest accumulating on the loan and so amortizes negatively. With the standard option ARM loan

The borrower has the option of paying the minimum payment, calculated on a 30 or even 40 year amortization at a 1.0% or 2.0% or 3.0% interest rate. Or the borrower can pay a payment that covers interest only. Or he can pay the 30-year or 40-year amortization payment or the 15-year amortization payment.

If the borrower pays interest-only each month, the balance remains unchanged. However, the interest rate he is paying is higher than the rate he could have gotten had he applied for an interest-rate-only loan instead.

If the borrower chooses to pay only the minimum required payment, then the balance owing increases each month that the borrower pays the minimum payment, that is, the loan amortizes negatively. To some borrowers that is a terrifying thought. To the more courageous, it was a terrific thought: In the greater Seattle area, property values in the past going up 10% to 20% per year, it was not a great concern if the balance owing on the loan went up 2% per year. Now that values have stabilized and begun to decline, attitudes may change.

Some landlords love the Option Arm loan. With extremely low minimum required payments, the investor has money left over from rent income to pay the mortgage payment in full and maybe more to cover negative cash flow: for example, to cover the loss of rent if a tenant fails to pay and has to be evicted, or to pay for a new electrical system or a new hot water heater.

With the standard option ARM loan, the minimum payment will typically rise 7.5% each year.

One drawback of the option ARM is that although the required minimum payment is low and predictable, the interest rate is adjustable each and every month. The interest rate is the total of an index plus a margin. The margin is fixed, and represents the lender's consistent, guaranteed profit level.

The margin fluctuates with the markets and might be from 2.50% to 3.50% depending on the index chosen.

The MTA index is a popular one, so let's use that one as an example. It is the average of the last 12 months of interest rates on the US 1-year treasury bill. Rates on T-bills are fairly stable and change slowly, and because an average is taken of the rate over the last 12 months, the MTA is said to be a "lagging index." The last time I reviewed this page (April 5, 2008), the MTA rate was 3.794. Another popular index is the one-year Libor. See Mortgage-X for the various indices.

The index plus the margin typically ranges from the high 6s to the mid 8s, and it depends on whether the property is owner or non-owner occupied, whether the borrower fully documents or states his income, the loan-to-value ratio, and the credit score. The interest rate is adjusted monthly. The lender sends the borrower a letter each month giving him his payment options to the penny.

With the option ARM loan the lender will pay the broker a significant rebate, meaning that the broker will not have to charge the borrower points. Thus, the borrower's closing costs are lower.

Most option ARM loans come with pre-payment penalties for one, two, or three years. Lenders pay loan officers higher rebates to deliver them option ARM loans with long pre-payment penalty periods. However, there are one-year and no-pre-payment penalty option ARM loan available. The borrower might have to pay points and the loan officer might have to be satisfied with a lower rebate.

Option ARM loans can be obtained on a fully-documented or stated-income basis. Rates are a little lower for one who qualifies full doc.

One must qualify at the fully amortized payment level, not at the initial start rate.

When borrowers state their income, lenders go to www.Salary.com to determine whether the income stated is reasonable for the borrower's line of work.

The option ARM has been used for retired people who want to stay in their home but who do not want to pay fully amortized loan payments. Again, with property values going up 10% to 20% per year, it is not a great concern if the balance owing on the loan goes up 2% per year. An elderly home owner’s $400,000 home may be going up in value $30,000 to $60,000 each year, so it would be a very stupid move for him to sell it and go rent an apartment, regardless of what the mortgage gurus say in the newspaper.

A reverse mortgage is a better option than an option ARM loan, however, to get a reverse mortgage both spouses must be 62 or older, and they must have around 50% equity in the home. A person who is under 62 or who does not have 50% equity in his home might resort to an Option ARM loan as a compromise.

THE SECURE OPTION ARM

With the standard option ARM loan, the minimum payment level rises 7.5% each year and the interest rate changes monthly. However, some lenders have offered a "secure option ARM" loan, where the minimum payment and the interest rate are both fixed for five years.

Typically the fixed interest rate is in the low 7s. The borrower may pay interest-only on this loan at an interest rate that is 3.0 points lower than the fixed interest rate, which typically yields an interest-only payment in the low 4s. A big advantage is that the borrower is allowed to qualify at the interest-only level in the low 4s.

The only downside is that the minimum payment level on the secure option ARM is a little higher than on the true option ARM.

Before you sign up for an option ARM loan, fax your good faith estimate and your credit report to me and I'll give you my opinion for free. I'll tell you if it is appropriate for you and whether the charges are fair.

Call me at 425-774-6611 or 888-999-2022 for further information. Or e-mail me. The fax number is 425-776-8081. Click here to sign up for our e-mail messages, our printed mailings, or to request a call back.

For details about how to apply go here.