First-time home buyers and homeowners who want to refinance have probably seen the names Pay Option, Pick-A-Payment, Cash Flow ARM, and Option ARM. These loans are very popular because they offer a low introductory or start rate and several monthly payment options. Although the initial low interest rate and the low monthly payment option are tempting, this type of mortgage loan is not right for everyone. This article gives you basic information about Option ARM loans, their distinctive features, and their potential risks.

What is the difference between Pay Option, Pick-A-Payment, Cash Flow ARM, FPARM, and Option ARM loans?

There is no difference! These are all the same type of loan. We’ll use the term Option ARM in this article. ARM, which is short for Adjustable Rate Mortgage, means that the interest rate on the loan increases or decreases according to a schedule set out in the loan document. With Option ARM loans, the interest rate is recalculated every month after the introductory    period. ARM loans have been around for years. The relatively new Option ARM differs from other ARM loans because it offers four payment options each month.

I like the idea of a low introductory interest rate. What could be bad about that?

The word introductory is the catch. These loans are attractive because the introductory interest rate, or start rate, can vary from 1.25% to 4.25%. The more money you put down and the better your credit standing, the lower the start rate. The start rate for Option ARM loans is only in effect for the first one to three months of the loan. The start rate is used to calculate the minimum payment option for the first 12 months of the loan and may not cover the total accrued interest each month.

My mortgage broker mentioned something about the COSI index and a margin. What is he talking about?

If you were going to get a regular fixed-rate, 30-year mortgage, you would not have to worry about indexes and margins, because your interest rate never changes in a fixed-rate loan. With Option ARM loans, your interest rate will be recalculated every month after the introductory period and will go up or down over the life of the loan, depending upon the index. It will never be as low as the initial start rate, so choosing an Option ARM loan means that your payments will increase after the introductory period.

Let’s look at index first. Option ARM loans use a formula that adds a margin to the index to calculate the adjustable interest rate. ARM interest rate changes are determined using a financial market index. COSI, or Cost of Savings Index, is just one of several indexes used with ARM loans. All ARM loans include a paragraph that describes which index will be used to calculate the interest rate, how the new interest rate will be calculated, and how often the rate adjustment will occur. The index can change each time the interest rate is recalculated, but the margin number will never change.

Now let’s look at margin. The margin is the percentage added to the index figure at each rate change to determine the interest rate until the next change period. The margin is set by the lender when you sign the loan. The margin figure does not change during the term of the loan. The total of the index and margin is known as the Fully Indexed Interest Rate. See the chart below for an example using 3.50% as the margin.

When the introductory period ends, the interest loan rate is recalculated every month, using index and margin rates to determine the Fully Indexed Interest Rate for the coming month. Then, your interest rate will rise and your monthly payments options will fluctuate depending on the index rate.

What are the various payment options?

Option ARM loans generally come with four payment options every month—Minimum Payment, Interest-Only Payment, Fully Amortized Payment, and 15-Year Payment.

Minimum Payment: The minimum payment is the lowest of the four payment options and carries the most risk. This payment is a fixed amount and is recalculated once a year. A payment cap, usually 7.5%, limits how much this payment can increase or decrease each year. The minimum monthly payment does not include any payment towards the loan principal, so when the start rate period ends, it will not cover the full interest due each month. This means that instead of lowering the amount you owe on your loan, the loan amount will increase each month, because the outstanding, or deferred, interest will be added to the principal balance. This is called negative amortization. It means that you will owe more money than you borrowed.

When the principal balance exceeds the value of your home by more than 10% -25%, the lender will recast (recalculate) the loan. The new minimum payment could be drastically higher, perhaps unaffordable. What seemed like a great bargain when you signed the loan could now cost you your home. If you owe more money than your home is worth, selling your home will not pay off the loan. You will still owe money to the lender.

Interest-Only Payment: When you choose the interest-only option, you will be paying all the interest that is due for that month, based on your current interest rate, but you will not be decreasing the loan principal. This payment option increases or decreases, depending on the Fully Indexed Interest Rate. After 15 years, the loan will be recast and you will have to pay off the total principal balance and the interest in the remaining 15 years. Your monthly payment will go up, because you will be paying off a 30-year loan in 15 years. Here too, if property values decline, you will owe more than your home is worth.

Fully Amortizing 30-Year Payment: Selecting this payment option means that you will be paying both interest and principal. The amount will vary each month according to the Fully Indexed Interest Rate for that month. With this option, you will be acquiring a little more equity in your home with each monthly payment. It is advisable to choose this payment option as often as you can.

Fully Amortizing 15-Year Payment: This is the highest monthly payment option, but it has many benefits, if you can afford it. The loan will be paid off twice as quickly, and you will save more than half of the total interest costs of a 30-year loan. As with the Interest Only and Fully Amortizing 30-year payment options, the amount will vary according to the Fully Indexed Interest Rate for the month. See the chart below for a sample of monthly payment options for a $150,000 loan with a 2.75% initial rate, 30-year term, 3.50% margin, and 3.140% COSI Index.

So, how do I decide if an Option ARM is a good loan for me?

Look at the payment options below and ask yourself which payment you can afford. If you can only afford the minimum payment, this loan is not right for you. Each minimum payment you make is going to add $217.64 to your loan balance and subtract from the equity in your home. Home ownership is about investment, gaining equity, and improving your financial situation. You should choose a loan that will help you accomplish those goals.

If you see that you can select the third or fourth payment option most months, then this loan might work for you. If you work on commission or are seasonally employed, a flexible payment schedule could be better than a fixed payment schedule for you, as long as most of your payments would include interest and principal. Remember, however, that Option ARM interest rates are subject to change every month and a steep rise in the Index will mean a steep rise in your monthly payment options. How will you cover a sudden, steep increase in your monthly payments?

Finally, consider the economy. Will home values in your neighborhood remain stable or increase over the next few years? Is your job secure? Is there an increase in unemployment in your area that might affect you? Do you expect your income to grow each year to meet the increase in loan payments that are the rule more than the exception for Option ARMs?

Don’t let a low introductory interest rate lure you into thinking you can afford an Option ARM loan. Sit down and work out your financial picture before you commit. Know what you can afford. Insist that the broker or loan officer take the time to fully explain the terms of the loan to you before you sign. Protect yourself and your investment. Shop around for the best rate, or a different loan that is better suited to your situation.

This article appeared in the January-February 2005 edition of Looking Out for Your Legal Rights^®.