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 would
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, which is 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 comes in.
The loan carries and adjustable interest rate, and this rate can adjust as often as every month. If the borrower is paying only the minimum payment, then he or she isn't even paying enough to cover 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 himself unable to pay the loan and may have to default
and the lender could find himself holding a note that is worth far more than the house that it represents.
The option ARM is a loan that 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 he or she can afford. Unfortunately, that describes a lot of buyers who are taking out this type of loan. Anyone who is considering a home purchase should be very careful if this type of loan is offered, as it could leave you both bankrupt and homeless.
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