Option ARM - A Sure Ticket to Trouble

Option ARM loans can make your home unaffordable

Anyone who has been paying attention to the real estate market in the United states knows that prices have gotten completely out of hand in the last five years. Housing prices have increased much faster than salaries and homes have become more unaffordable than ever. And yet, home sales have steadily increased during this period. There are two factors that account for this - interest rates that are near record lows and home loan options that have become more flexible than ever. 

The variety of loan options available to the buyer today literally numbers in the hundreds, and the more popular loan types today all include variable interest rates, in order to allow the greatest flexibility in fitting marginal buyers into homes. One type of loan, known as the option ARM, also known as the Pick Your Payment loan, is the most dangerous type of home loan ever created by the lending industry. Anyone who is considering an option ARM should be aware that this risky product could leave the borrower with payments that they cannot afford and a home that may be worth quite a bit less than the loan amount.

The option ARM is a mortgage with a variable interest rate that can adjust as often as every month. Each month, the borrower has four payment choices: a payment based on a 30-year repayment, a payment based on a 15-year repayment, and interest-only payment, and a “minimum” payment. The minimum payment is based upon an introductory interest rate that applies only for the first month; that rate can be less than 2%. While the borrower may elect which type of payment to make every thirty days, most choose the minimum payment. The problem with that is that the interest rate increases after the first month, and possibly every month thereafter, but the minimum payment is based on the first month’s interest. Paying the minimum payment virtually guarantees that the payment will not ever cover that month’s interest, resulting in a loan principal that increases over time. Not only does the principal increase, but as interest payments are based on the outstanding principal, the interest increases, too. Instead of the principal declining over time, it actually grows, resulting in what is known in the industry as negative amortization. Most home buyers take out a loan and hope to reduce the amount that they owe over time. With an option ARM, the amount will almost certainly go up unless buyers pay extra principal, which few do. Led to its logical conclusion, this loan will eventually lead to a situation where the buyer cannot afford to make payments and the home is worth less than the debt upon it. This could result in loan default.

There are circumstances where such a loan might be worthwhile, such as when experienced real estate investors purchase property for a quick turnover, but in most cases, this loan is a bad idea. It is one of the worst possible options for the very buyers who are using it the most - the buyer who cannot afford a home using any other means. The risks associated with an option ARM are high, and buyers are encouraged to avoid this loan, if at all possible.