| How about a mortgage with an interest rate as low as | | | | rate. This rate may be 7%, 8% or higher. |
| one or two percent? Wow! The payment on an | | | | Amortization Period: The actual number of years it will |
| adjustable rate mortgage may sound great but as the | | | | take to pay a loan in full. |
| old adage goes: if it sounds too good to be true, it | | | | Negative Amortization: The increase in mortgage debt |
| probably is. | | | | resulting from the difference between the fully indexed |
| At the time this article was written, the Federal | | | | rate and the payment rate (i.e. loan= $300k, payment |
| Government borrowed money at 4.64% APY for a | | | | rate =1%, fully indexed rate = 7%, then at the end of |
| one month term, so can an individual homeowner | | | | one year NEG AM could = $300k * (7% - 1%) = $18k |
| borrower money at a rate lower than our | | | | and your loan at the end of the year = $318k). |
| government? The simple answer is no. Can this still be | | | | These are the basic terms that need to be understood |
| a good loan? Yes, for a select few who understand | | | | to begin to estimate the risk and rewards of an Option |
| how it works. The remainder of this article will cover | | | | ARM. There are also payment and rate adjustment |
| the basic questions you should ask when considering | | | | caps that offer some additional protection for the |
| the negatively amortizing loan commonly referred to | | | | borrower. The Option ARM is an extreme way of |
| as an Option ARM. | | | | leveraging real estate and managing cash flow. |
| First, let's define some important terms. | | | | Theoretically, the borrower is making a rate of return |
| Payment Rate: The percentage rate used to calculate | | | | higher than the rate of negative amortization. If this is |
| your minimum monthly payment. It is typically the | | | | the case then the Option ARM works well for that |
| artificially low rate of 1 to 3% (or any rate equal to or | | | | borrower. Another suitable fit for this loan type is a |
| lower than the One Year T-Bill rate: currently 5.23%) | | | | borrower that will experience a dramatic increase in his |
| that is being advertised by your lender. Remember | | | | income in a few years and the monthly savings are |
| that the government borrows money at what is called | | | | more precious at this present date. |
| the "risk free" rate and everyone else pays a higher | | | | The sad reality is that some lenders market the Option |
| rate that reflects a "risk premium". | | | | ARM as if that low, low payment rate is the actual |
| Index: The particular statistical indicator tied to your | | | | interest rate and applicants flock to this type of |
| loan. This value may rise or fall over time and this may | | | | financing without a true understanding of negative |
| in turn raise or lower the interest rate on your loan. | | | | amortization. Even worse is the lack of understanding |
| Some examples of indexes for the Option ARM are | | | | by many participants in the mortgage industry. Inherent |
| the Monthly Treasury Average (MTA) or the Cost of | | | | in the Option ARM is the pre-determined limit to the |
| Funds Index (COFI). | | | | amount of negative amortization permitted. That limit |
| Index Value: This is the numeric value of your index | | | | may be anywhere from 10% to 25% of the original |
| today. You can check the value of the index in the | | | | loan balance. Regardless of any payment or rate |
| Wall Street Journal or other similar publication at any | | | | caps, when the negative amortization increases the |
| time on your own. | | | | mortgage balance to that pre-determined threshold |
| Margin: This is a numeric value that does not change | | | | then all bets are off. The borrower can no longer pay |
| over time. It is important to note that your margin is | | | | that low, low payment rate. The borrower will also no |
| negotiable. A big mistake that borrowers make in | | | | longer have the option of paying an interest-only |
| obtaining an Option ARM is in failing to negotiate the | | | | payment. The borrower will then be faced with having |
| margin. | | | | to pay a fully amortizing payment at the fully indexed |
| Fully Indexed Rate: Now we are finally getting to the | | | | rate. In a worse case scenario, this could result in an |
| real interest rate you will be paying on your loan. The | | | | almost tripling of the minimum payment required before |
| index value plus the margin equals your fully indexed | | | | the end of the second year. |