Option ARM - The World's Most Dangerous Mortgage

Home prices have reached record levels, and in many parts of the country, homes have become nearly unaffordable. Real estate has replaced tech stocks as the hot investment, and many have sold their stocks to jump into investment property. However, real estate prices have increased at a far greater rate than salaries, prompting the lending industry to introduce numerous mortgage options for borrowers barely capable of purchasing a home. Most of these loan types feature adjustable interest rates and minimum down payments. One of these, the option ARM, is the most dangerous type of loan ever introduced. Borrowers considering an option ARM should be aware that this loan could leave them with a loan worth far more than the home it’s used to buy and with a loan they cannot afford to pay. The option ARM is not for the squeamish.

So what exactly is an option ARM? An option ARM is a mortgage with an adjustable interest rate that typically gives the borrower four different payment choices each month. The first choice is based on a 30-year amortization table; the second on a 15-year amortization table. These correspond to payments for adjustable-rate 30 and 15-year mortgages, respectively. The third choice is an interest-only payment, which pays the interest that accrues during the month but pays nothing towards reducing the loan amount. The fourth choice, the one that makes this loan so dangerous, is called the "minimum payment." The minimum payment is calculated upon the first month’s interest rate, usually a very low "teaser" rate that can be as low as 1-2%. Most borrowers with an option ARM opt to pay the minimum payment each month, and that’s where the trouble begins.

The loan carries an adjustable interest rate, which can adjust as often as every month. If the borrower pays only the minimum payment, they aren’t even covering that month’s interest on the loan. What happens then? The unpaid interest that has accrued is added to the loan principal. The principal can actually grow larger, and as interest due is calculated on the loan principal, the interest due will increase as well. Interest rates are currently near all-time lows and are sure to increase. A buyer who continues to make minimum payments on an option ARM will find that the principal on the loan is actually increasing over time. This is known as negative amortization.

In a negative amortization situation, only bad things can happen. The lender can require refinancing under certain conditions stated in the loan agreement. The buyer may find themselves unable to pay the loan and may have to default. The lender could find themselves holding a note worth far more than the house it represents.

The option ARM is best suited to investors and homeowners who only intend to keep the home for a short time. It is not a good choice for anyone who may be using it to buy more home than they can afford. Unfortunately, that describes many buyers taking out this type of loan. Anyone considering a home purchase should be very careful if this type of loan is offered, as it could leave you both bankrupt and homeless.