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Option ARM's
This loan offer lots of flexibility, and also lots of risk. The Option ARM gives you four payments choices (or options) each month. You can either make low "teaser" payment, you can pay the fully adjusted rate, you can pay only interest, or you can make a 15 year fixed payment. This loan can work well in many circumstances, or it can be a complete disaster if it's the wrong loan for you.
Option ARM's are confusing to the consumer because because of the unfamiliar concepts involved. These programs were often pushed on the consumer by banks who enjoyed a high profit margin on them, and didn't bother to explain the risks involved. Countrywide and Washingon Mutual have become famous for this practice.
One confusing concept is "negative amortization". I will discuss negative amortization or "deferred " interest later, but first let me back up and explain the concept of amortization.
Amortization means that scheduled monthly payments (which are the same each month) are large enough to pay the interest and reduce the principal on your mortgage. Every time you make a payment, you are reducing your principal and owing less than you originally borrowed.
With an interest-only loan, you are not paying off any principal, but you are keeping up with the interest that is due. At the end of the day, you will owe the same amount you originally borrowed. But with an option ARM -- one that has the potential for negative amortization -- you may not be paying enough to even keep up with the interest that is due. The unpaid interest is deferred, and added to the unpaid principal balance. The deferred interest will be paid off (from the equity in your home) when you sell or refinance your house.
How Do These Loans Work?
The option ARMs start with an initial (or teaser) rate which is much lower than the 30 year fixed rate (example: 30 year fixed is 6.25%, teaser rate is 1.95%). This initial rate is in effect for a brief time (usually 1 or 3 months), then the loan becomes "fully indexed", which means the new interest rate becomes the sum of the index plus the margin -- and these indices change monthly.
After the loan becomes fully indexed, the indexed rate changes each month. A benefit of this loan is the index it's tied to is very slow-moving. That means your payments will change very slowly. If you pay the "fully indexed" rate, you will not incur negative amortization.
There is no cap on the monthly rate increase, although there is a lifetime cap on the loan. That lifetime cap is typically lower than the lifetime caps on the hybrid adjustable loans.
Furthermore, you have the option to pay the teaser rate for longer than the initial period if you would like to defer some of the interest. This is where the negative amortization feature comes into play.
Example: on a loan of $250,000 if the teaser rate is 4.95% (payment of $1,334) and the fully indexed rate is 8.95% (payment of $2,002), you can choose to defer the difference of $668 until you sell the home or refinance, or at any time later in the loan. You can make decision each month as to whether to pay the teaser rate or the fully indexed rate.
Another feature of these loans is the payment cap : the payment cannot go up more than 7.5% per year (please note that we are talking about a cap on the payment, not the rate.)
Example: if the teaser rate was 4.95% the first year (payment of $1,334), then the "teaser" payment during the second year cannot exceed $1,434, which is 7.5% higher than the previous payment.
The negative amotization comes into play only if you continue to pay the minimum payment (your original teaser payment plus plus 7.5% per year) and never keep up with the true interest owed.
This means that even after making many payments, you could owe more than you did at the beginning of the loan; rather than amortizing in the normal fashion where the principal balance goes down over time, your loan has amortized negatively, i.e., the balance has increased. In the past, people didn't worry about this feature too much, as property values were going up. However, now that some values have gone down, this has finally been recognized as a riskly loan.
If you are thinking it still might be a good option for you, please take the time to understand the risks of this loan as well; e.g., a job location where you are forced to move before the property has had time to appreciate.
The Indices
The COFI Index
This index reflects the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB, and other sources of funds. The 11th District represents the savings institutions headquartered in Arizona, California and Nevada.
Since the largest part of the Cost Of Funds index is interest paid on savings accounts, this index lags market interest rates in both uptrend and downtrend movements. As a result, ARMs tied to this index rise (and fall) more slowly than rates in general, which is good for you if rates are rising but not good for you if rates are falling.
The MTA Index
The Monthly Treasury Average is a relatively new ARM index. This index is the 12 month average of the monthly average yields of U.S. Treasury securities adjusted to a constant maturity of one year. It is calculated by averaging the previous 12 monthly values of the 1_Year CMT. Because this index is an annual average, it is more steady than the 1-Year CMT index. The MTA index generally fluctuates slightly more than the 11th District COFI, although their movements track each other very closely.
Advantages of COFI and MTA ARMs :
Flexibility in the monthly payment. Every month, you receive an invoice from the lender, and will have 4 different payment options: 1) the "teaser" payment (also called the minimum payment), 2) the fully indexed payment 3) an "interest only" payment or 4) a 15-year amortization payment. You can choose a different payment option each month f you like.
Tax Planning. COFI ARMs may be used for tax planning. You can defer interest payments and at the end of the year, analyze your tax situation. If it serves your tax interests, you can make a lump sum payment toward any interest that has been deferred and deduct it for tax purposes.
Disadvantages of COFI and MTA ARMS
Risking Your Home Equity: If you defer interest each month, you could end up owing more than you originally borrowed. This will reduce your equity position in your property.
Harder to Budget: If you choose the full payment option, your payment will vary from month to month.
Prepayment Penalty: These loans often come with a prepayment penalty, or you may have to pay points to avoid a prepayment penalty.
Harder to Take Out Equity Line: Should you decide to tap into your home’s equity by taking out a second mortgage or equity line, you may have problem: many lenders in this market will not take a position behind a loan with the potential for negative amortization, especially if you have a history of making only the minimum payment.
Don’t Be Misled by Past Performance: These loans have performed very well in the past few years where rates declined significantly; i.e., monthly payments actually declined month after month. The indices on which they were based were at all-time lows. However, in our new environment of rising rates (since mid-2004), these loans are not expected to perform as well and may not save you as much money as they have in the past.
Summary: COFI and MTA ARM products can provide more opportunities for financially savvy borrowers who seek more customized, and ultimately less costly, home-finance choices. However, because the COFI products do not offer periodic rate caps, you need to be particularly careful to study the product before you make your choice.
To see how the indices have performed, see www.mortgage_x.com/general/indexes/cmt.asp.
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