What has become known as an "Option ARM" is not the best option in most cases.

What has become known as an "Option ARM" is not the best option in most cases.

The Mortgage market has been overwhelmed by lenders pushing, even specializing and promoting this loan called the "Option ARM". You may have heard it on the radio, you may have seen it on TV, I guarantee you have received something in the mail about it. It promotes the 1% payment rate, and boasts about being fixed for 5 years, or more. The reality is, there are 100's of options out there for this loan, and I have searched the blog posts front to back, and don't really see an unvailing of what this loan is. I don't want to come off like I am bashing this loan program, but I want to stress that there are good ones and bad ones, and I hope I can explain the pros and cons so that you understand my point of view.
Reality, this loan gives you 4 payment options. It gives you the flexibility every month, to choose the payment you want to make, and make it. 4 hypothetical payments on a $300,000 loan are listed here.
1% Start Rate $964
7.5% Interest Only $1,875
7.5% 30 or 40 year Amortized $2,097
7.5% 15 Year Amortized $2,781
The first thing that needs to be known about this loan, and many lenders won't focus on, is that if you make this first payment of $964, your loan balance will INCREASE. Again...INCREASE. Ok, If I am every telling someone about this option, this is the thing I stress the most. The basis for this loan is that if you make the $964 payment you loan balance will increase $911 every month you make this payment. This loan was designed for people who are self-employed or on a commission only type position where your income may vary month to month. I believe in this loan in some cases, but those cases are few and far between.
Cons of this Loan:
People promote the 1% payment rate, but don't explain that in some cases, the actual interest rate the bank is charging you, the 7.5%, is costing you $911 more than the 1% Start Rate that you can pay. Therefore until you make more than the Interest Only payment, your loan balance will keep going up and up.
The 7.5% interest rate is adjustable in most cases, though lenders have rolled out new loans like this that are fixed for 5 years, so that fear of your loan adjusting doesn't come until after year 5. The loans are based on an Index and a Margin. The Index is what changes from month to month. You may have heard of these indexes, they are called the MTA, CODI, COSI, COFI, or Libor. There are others out there, but you get the idea. The index is what makes this loan adjust. As the index changes with the market, up or down, your interest rate changes accordingly. The margin is what the loan officer chooses to give you, based on how he/she wants to structure your cost and type of prepayment penalty if any. Usually the choice is for the highest margin and largest prepayment penalty, because the loan officer will make more money. You don't have to have it that way, always ask questions to get the best deal for you. If you have a short term outlook on the property, like 4 or 5 years, then maybe this program would work, but if you are in this home for the long run, it just isn't the loan for you.
Pros of this Loan:
Flexibility is the only pro. If you use this loan how it was designed to be used decades ago, then you can make it work for you. But, I have an alternative solution for you, that makes the most sense in most cases.
If you can qualify for this loan, there are two things that are likely, you have a decent credit score, and you have some equity. (There are exceptions, but discussing exceptions would probably put you to sleep :)) These loans are usually offered if you have 10% equity or better. If you have decent equity and credit score, my recommendation is to look into a more stable first mortgage, like a 30 year or 40 Year fixed, even a longer term adjustable rate mortgage like a 10 Year ARM with an Interest Only Option, that will give you more stability than the Option Arm, but the key with why this is a better solution, is you can get a 2nd mortgage, or my recommendation of a Home Equity Line of Credit (HELOC), behind that first mortgage, to offer the flexibility you are looking for. (Look for my blog on Home Equity Line of Credit's for more detailed information). The main reason for using this scenario over an Option Arm is purely interest cost.
Option Arm Interest Cost at 7.5% listed above = $1,875 (Look Above)
Same Loan Amount, Interest Cost on a 10 Year Interst Only at 6.5% = $1,625
The difference is $250. Yes... $250 per month just in interest!!!!!
If you choose an option arm over a standard ARM, you are losing $250 per month (in most cases). You want flexibility, get a 10 Year Interest Only or 30 or 40 Year Fixed, and get a Home Equity Line of Credit in addition to it, so that when you have months where the larger payment of $1625 is too much, you can use the HELOC to make up the difference. But, and this is a big but.., you must try to pay down that HELOC when you can. If you don't, your loan balance will keep increasing and increasing, and unless you are fortunate to have $100,000's in equity, your investment will go away, and you will be forced to sell because you can't afford the ever growing mortgage, with little to show for it. I may sound harsh, but the reality is, this can happen, and people in this business don't stress that fact. When homes were appreciating like crazy, maybe 10-20% per year, this loan wasn't really a factor, because your equity would grow. Those days are over for now, without a change on the horizon.
Don't make that mistake of not examing ALL of your options. If you feel you are being pressured to take one loan over another, there is a reason, that loan officer has an alterior motive, usually based on pay. Option Arms can pay a loan officer up to 3% of the loan, that the bank will pay. Not you directly, but indirectly, the bank pays it directly. That money is coming from your interest rate, and doesn't need to be there. It also comes from the prepayment penalty he/she is telling you that you have to have, well, you probably don't "have" to have it. Always ask questions.
Call or email me if you have any questions, this may be the only option for you, but I don't think it needs to be. I can lend in California and Oregon. If you aren't located in either, still call, I don't want you to get something you shouldn't. I don't mind, I love what I do. You can send me an email to jvetter@mercurylending.com or get more information at www.jonathanvettermortgage.com. Emails go to my computer and my phone and I can respond quickly in most cases. If you feel comfortable talking about it, call my cell phone at 650-465-5846.

Tags: Neg-Am, Interest Only, Index, Refinance, Option ARM, Pick a Payment, Margin, Points Sub-prime