Option ARMs are a dangerous option

Hundred dollar bill folded in shape of house

When daredevils are about to perform a hair-raising stunt, they often admonish viewers: "Don't try this at home."

We think a similar warning should accompany one of the newer twists in mortgage financing: option adjustable-rate mortgages or option ARMs. Unless you are extremely well-versed about these complex loans, you risk a nasty surprise that could cost you your home.

An option ARM is a type of adjustable-rate mortgage with as many as four different monthly payment options and, depending on its underlying index, an interest rate that could change every month.

In most cases, each month the homeowner gets to choose one of four ways the mortgage check can be treated: 

The goal of the option ARM is "to get the payment as low as possible," explains George Yacik, a vice president at SMR Research, a New Jersey firm that studies the home mortgage market and home equity lending.

The option ARM is a direct result of skyrocketing house prices across the nation. Since many first-time buyers need help getting their first home, more of them are turning to option ARMs.

While fewer than one in 100 borrowers took out option ARMS in 2003, more than 12 in 100 are doing so this year, LoanPerformance a company that follows lending trends, recently told Business Week magazine.

"Without them, a lot of people would be shut out of the housing market,'' Yacik says.

But lenders often attract borrowers with startling low initial rates of 1% or 2% and the promise of a minimum monthly payment that is far less than any other mortgage could possibly offer.

Borrowers, especially those who signed up for an option ARM because they couldn't afford a more traditional loan, quickly get into trouble when: 

Some ARMS periodically require borrowers to catch up on all unpaid interest as well as any interest that has accrued on that interest with a type of balloon payment.

Others have "principal caps.'' If your debt reaches 110% of what you originally borrowed, the minimum and interest-only options disappear and you have to start paying all of the interest and part of the principal every month.

Don't have it? Want to refinance and get out of the loan? Many option ARMS also impose penalties of $10,000 or more if you try to pay them off early.

So if you don't understand how an option ARM works in general, and how your lender's loan works in particular, you could slam into a financial wall in just a few years.

Let's look at how different repayment schemes affect an option ARM loan for $100,000 with a starting interest rate of 4.75% amortized over 30 years.

At the end of the first 30 days, you will owe $396 in interest. If you made the standard monthly payment, treating it like a conventional 30-year loan, you would send the lender a check for $521. That would pay that month's interest and reduce the total amount owed by $126, leaving you with a balance of $99,874.

If you treat an option ARM like a 15-year loan and pay $778, your interest would still be $396, and the remaining $382 would reduce the principal to $99,618. Both of the above examples whittle down the principal amount owed and also cover all the interest due.

But if you choose to make an interest-only payment, such as $396, that means you still owe $100,000 to the lender and have not built any equity in your home. Given that the interest charge could change every month, you also run a very real risk of facing larger monthly payments that don't reduce the principal.

Now let's look at what happens when you opt to make a minimum payment of $200 a month. Since that payment is less than the interest owed, the excess unpaid interest of $196 gets added to the principal.

In a month two, you owe the interest on $100,196. At 4.75%, that is $397. If you make only the $200 minimum payment again, you get the unpaid interest--this time $197 -- added to your principal so you would then owe $100,393.

As you can see, the longer you make minimum payments that do not cover the interest, the larger your debt.

You end up owing your lender thousands of dollars more than you initially borrowed. You could also face balloon payments or huge monthly payments that you can't afford on a house in which you have built no equity.

It's little wonder that George McCarthy, a housing economist at New York's Ford Foundation told Business Week that option ARMs are "like the neutron bomb." They're "going to kill all the people but leave the houses standing."

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