Option Arms are not for Everyone

One mortgage option for which you might qualify is called an Option ARM. It’s an adjustable rate mortgage that gives you the “option” of varying the amount of your mortgage payments from month to month.

The freedom to pay as much or as little towards your monthly mortgage sounds very attractive and it is, as long as the mortgage is managed properly. The problem with Option ARMs is that the many terms and frequent adjustment periods can be confusing and not everyone is a good candidate for this type of mortgage. Here’s some information that’s designed to help you decide whether an Option ARM makes sense for you.

Negative amortization

Probably the single biggest reason why people get into trouble with Option ARMs is negative amortization. Basically what this means is that your mortgage could actually grow bigger. With most other mortgage options, your mortgage principle reduces with each payment you make. This can happen with an Option ARM too as long as you resist the temptation to make minimum or interest only payments.

But when you don’t make a large enough monthly mortgage payment to cover the full amount of interest, that shortage gets added back onto the mortgage’s principle balance. A few hundred dollars added back onto the mortgage likely isn’t going to cause financial ruin.

But when a borrower repeatedly makes just the minimum payment, the principle balance can quickly grow quite large. And so can the monthly payments because the increased principle is increasing the amount of interest due each month. Unfortunately, it’s easy to fall into a pattern of making mortgage payments equal to the minimum due since that amount is typically several hundred dollars less than a fully indexed payment.

Recasting

An option ARM also isn’t a good option is you plan to remain in the home for more than 5 years. That’s because at the beginning of year 5 (and usually every 5 years thereafter), this type of mortgage is recalculated. In other words, the amount of interest that has been underpaid during the previous months is added onto the mortgage balance and then monthly mortgage payments are recalculated. It’s at that point that monthly mortgage payments on Option ARMs usually skyrocket and become unaffordable for many.

Option ARMs should never be used as a way for a buyer to buy more home than he or she can afford, either so if that’s something you’re considering, forget it! Initial interest rates on Option ARMs are unbelievably low and this low rate helps many qualify for higher loan amounts. But when the mortgage adjusts or is recast, a borrower whose income level has not increased usually will have trouble making the higher mortgage payments.

And finally, mortgage brokers don’t explain Option ARMs correctly. More often than not, they’ll sell the 1.75% rate instead of explaining the fully indexed rate.

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About the Author:
Melvin is the President of Affordable Home Equity Loans, Inc. in Tampa, FL.