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OPTION ARMs AND NEGATIVE AMORTIZATION

Before we end our discussion on adjustable-rate mortgages, I want to mention two characteristics of some potentially bad loan features — payment-option ARMs and negative amortization.

Payment-option ARMs — sometimes called “option ARMs” or “pay-option ARMs” — have a series of payment choices built right into the loan program itself. Those options include the contract or initial pay rate, an interest-only plan, a fully indexed plan, and a fixed-rate plan all rolled into one loan.

It sounds confusing. And for the average buyer it is.

The contract or initial pay rate can be super low: 3 percent, 2 percent, or even 1 percent. It has an index and a margin just like any other ARM; and each month you actually have a choice of which to pay. You have a pay option. Let's look at a typical scenario where you could pay a $250,000 loan amount.

Rate/type

Payment

1%

$ 804

5.75% interest only

$ U97

5.75% fully amortized

$ 1,458

6.25% 30-year fixed

$ 1,539

So who would pay the 30-year fixed rate or the 5.75 percent fully amortized rate? Why wouldn't everyone just pay the initial pay rate or the interest-only rate? Because of negative amortization.

These loans have potential for the loan to negatively amortize, or actually grow rather than get smaller. The trick on these loans is that when you pay the 1 percent rate, the lender compares that to a fully amortized rate payment. If you don't pay at least the fully amortized payment, then the difference between the initial rate and the fully amortized rate gets added back to your original loan amount. That's not good.

Such loans have been around for decades, but until recently were they weren't promoted much to the general public. They're not inherently evil. They weren't designed to take away homeowners' equity. Rather, they can be viewed more as a financial management tool.

For instance, these loans could make sense when the borrower gets paid irregularly or receives a large annual bonus. The buyer could pay the minimum payment and make up for it when he gets his bonus or hits a big payday, erasing any potential for long-term loan growth.

Nonetheless, with all the loan choices out there, this is one simply to stay away from. Period.

 
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