At first glance, an Option ARM loan can seem like a great opportunity for someone who is looking to purchase a home with the lowest monthly payments possible. An Option ARM mortgage starts out with low "teaser" interest rates that are only good for a month but are extremely appealing. An Option ARM loan also offers the borrower his choice of payment type: a minimum payment, an interest payment, or an amortizing payment. And the minimum payment can be seductively low, offering a borrower with limited cash flow the chance to buy a larger property than he expected to be able to afford.
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The problem is that if a borrower makes only the minimum payment on his Option ARM mortgage each month, he will quickly find that he is sliding into debt. As the teaser rate expires and the actual interest rate rises, the borrower's minimum payments will not make a dent in the actual loan principal nor the interest that is rapidly accruing. The Option ARM loan will in fact be negatively amortizing.
As a result, within a matter of months, the borrower may find that he owes 115 percent of the original balance of his Option ARM loan - the magic number for lenders. At this stage, the lender will require that payments be adjusted to amortize the loan so that it can still be paid in full within the initially established time period (usually 30 years). This means that the minimum payment for the Option ARM mortgage that seemed so low at the start of the loan can double, triple, or even quadruple to keep up with the rising interest rate - leaving the borrower struggling to maintain his mortgage payments. What seemed like such a dream deal at the beginning of the process can rapidly turn into a nightmare.
Who Can Benefit from an Option ARM Loan?
An Option ARM mortgage is simply not meant for the non-savvy borrower. Ideally, this type of mortgage would only be offered for loans over $700,000, and it is not intended for first-time home buyers. It can work well for borrowers seeking to purchase a second home or a rental property, particularly if the borrower will be able to pay more than the minimum payment as often as possible or if the purchased home's value will appreciate more quickly than the debt on the Option ARM loan.
Choices beyond an Option ARM Mortgage
For borrowers looking for a mortgage other than an Option ARM loan - one that offers low payments without the trickery -- there are many choices, including other adjustable rate mortgages. A secure Option ARM mortgage can lock in an interest rate for a longer period of time, for example, meaning that the 115 percent mark will not be reached for several years. Even with this type of mortgage, avoiding making just the minimum payment will also keep the borrower out of negative amortization; making the interest payment, for example, would make more sense.
A 30-year option mortgage is another alternative to an Option ARM mortgage. With this type of mortgage, the interest rate is locked in, meaning that the borrower will never experience the severe payment shock that can occur with an Option ARM loan. This type of mortgage still offers flexibility in payment options, but without the large risk.
A third alternative for borrowers considering an Option ARM mortgage is an interest-only mortgage. With this type of product, the borrower's payments go directly toward the interest, rather than the principal, for a set period of time. Again, this can give the borrower the chance to make lower payments while avoiding the problems that come with an Option ARM loan.
Advice for Borrowers Who Already Have an Option ARM Mortgage
If you already have an Option ARM loan, what can you do? The answer is simple: get out of your loan as soon as is realistic. Begin making higher payments immediately, bearing in mind that your loan may have prepayment penalties involved. And as soon as you are able, refinance your Option ARM mortgage into something that is more reasonable - ideally, a mortgage with a fixed interest rate and one that will not bring any more surprises down the road.
Conclusion
When applying for any mortgage, the most important thing to remember is that you must ask thorough questions and read all paperwork before signing anything. An Option ARM loan may appeal to you at first, particularly if you have limited funds to use for your monthly payments. But if you take the time to understand the details of an Option ARM mortgage, you may instead wish to rethink your decision and go with a different plan. Remember that you always have choices and that a reputable mortgage broker should present you with them before you make your final decision.
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