The Fine Print On Option ARM Home Loans

In recent months, you can’t turn on the radio or pick up a newspaper without being told about so-called Option ARM home loans. The radio ads tell you if you’re paying more than $1608 per month for your $500,000 loan, you’re paying too much. And the newspaper headlines warn of financial doom from negative amortization.

So this month, we will go beyond the ad fluff and press headlines to see how this loan works and to see if it’s right for your situation. With this loan, there are three critical things to understand: (1) How the payment can be so low, (2) the adjustable rate feature of the loan, and (3) the payment “options” you have with this loan.

On the first point, our $1608 payment is based on a 1% rate amortized over 30 years. The payment includes principal and interest. Depending on your situation, this rate can be anywhere between 1% and 3%. In the Option ARM plan, this is the lowest payment option you can have.

The second point to understand is how the loan is adjusting. Like any adjustable mortgage, the Option ARM’s underlying rate is fluctuating. It is tied to a loan index that you and your mortgage broker choose. A common loan index is the Monthly Treasury Average, a rolling average of one-year Treasury securities, which (at press time) is at 2.9%. Then an ARM also has a margin, which is a fixed number based on your credit quality, home equity and other factors. For someone with good credit and about 10% equity, a margin might be 2.8%.

Your effective rate then is your 2.8% margin – which will never change – plus whatever the current index is at the beginning of a given month. So in this snapshot-in-time example, your effective rate is 5.7% (2.8% margin plus 2.9% current index rate). Using our $500,000 loan, the interest-only payment on this rate would be $2375, and the payment including principal and interest would be $2902.

This brings us to point three, the payment options. In these three options, you can pay $1608, $2375, or $2902. If you elected to pay $2902, then you’re paying all your interest for that month, plus paying down the loan balance by about $527. If you paid $2375, you’d be paying just your loan interest, and your loan balance would stay at $500,000. If you paid $1608, then your loan balance would increase by $767 – this is known as deferred interest or negative amortization.

Why then would you someone choose a loan where their loan balance could grow? The simple answer is that the payment is so low. It’s a good way for people that need a low payment to be able to buy a home. A more technical answer is that, even if your principal balance is growing (by taking the lowest payment option), your home’s value is appreciating faster than the principal balance is increasing.

As an example, let’s say you paid the minimum payment on $500,000 for one year. Your loan balance would be about $510,000. But even if we used a very conservative appreciation rate of 5% (about one-third of current levels), your home’s value would be $525,000. So you’re still ahead by $15,000 in the first year even when you’re only paying $1608 per month.

Another common reason people choose Option ARMs is when they’re buying investment property. Their goal is to have rental income cover mortgage, insurance and tax payments. So low mortgage payment is more of a priority than paying down principal. Investors are looking for equity through appreciation more than equity through loan pay down.

So as you can see, the fine print on Option ARMs is a bit more complicated than the ads and the press headlines make them out to be. But they are a great loan for the right circumstances. In the end, selecting Option ARMS or any other loan comes down to two things: (1) What are your financial objectives? and (2) What is your time horizon?

Next time you talk to your Certified Mortgage Planning Specialist, if you answer these questions carefully and deliberately, you will always end up with the right financial plan … and the right loan to execute than plan.

Basis Point of Disclosure: This article originally appeared in a mortgage newsletter published by Julian Hebron, a Certified Mortgage Planning Specialist and the founder of The Basis Point.