Answer : "Options Arms" are
called this because each month borrowers are offered several options when making their mortgage payment:
1) Minimum payment,
2) Interest-Only payment,
3) 30 year amortized payment, and
4) 15 year amortized payment.
We're going to focus the answer on the minimum payment because that is where most people get
confused.
Minimum payments start out at payment rates as low as 1%, so a minimum payment on a $500,000 loan
might be $1,608.20. However, the loan itself is an adjustable rate mortgage at a much higher rate, say 5.85% so the interest
due could be $2,437.50. the difference of $829.30 is called "deferred
interest" or "negative amortization". In other words, the borrower is now $829.30 deeper in debt.
Although the minimum payment
may start as low as 1%, every year the payment increases by 7.5%. The $1,608.20 first year payment goes to $1,728.82 the 2nd
year, $1,845.48 the 3rd year, and so on. Most programs go 5 years before recasting into a fully amortized loan based on the
current rate and the balance due.
If the borrower makes the minimum payment every month and interest rates climb, the amount of "deferred
interest" could reach the limits of the program (typically 110% of the original balance) and force recasting before the 5
year time limit. This can come as quite a shock to folks who did not understand the program and thought they had found the
cheapest mortgage payment ever. For instance, the example we used earlier would produce a recast payment of $5,792.73
if the rate on the arm were to reach it's maximum rate of 12.0% at 110% of the original loan amount just at the 5 year
limit. Many analyst are concerned that uniformed borrowers will be forced to walk away from their homes and debts should rates
rise quickly and they continue to make minimum payments.
