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Option ARM Mortgage- Part 1 - What it is and How it Works
Due to the number of possible ways to use this mortgage program, there are 4 parts to read through
Part 1: The Option ARM - What it is and How it works
Part 2: The Option ARM for Borrowers with Variable Income
Part 3: The Option ARM for the Involved Investor - Leveraging your Equity
Part 4: How the Negative Amortization can be used to your Advantage
Part 5: Possible Disadvantages - Know the risks
Overview
The Option ARM is one of the most innovative programs available and is a product for using your mortgage and your equity to actually make you more money. This mortgage is best for borrowers who either are looking to leverage their home's equity more actively or are borrowers with income that is variable during the year.
It is called an Option ARM because you get 4 choices every month, you have the option of how you want to pay your mortgage and change from one choice to the other every month when the bill arrives. The statement has the choices figured for you and you can choose from a payment that will pay off the loan in 30 year or 15 years, an interest only payment or a minimum payment based on your special low start rate that comes with the loan.
There are descriptions of how this loan really works and scenarios describing how you would benefit when you have a variable income, are investing the money elsewhere and how it works when the value of homes are rising. I have also tried to cover the possible negative situations where this type of loan could put you into a worse situation than you are in now.
Features of an Option ARM
- 4 choices evey month
- Available in either a 15, 30 or even a 40 year
- The Minimum payment is based on 30 year fixed Start Rate. This minimum increases 7.5% each year. The start rate can be 1.25% or 2.25% depending on LTV and credit rating.
- The rate of interest is tied to an Index. Either the Monthly Treasury Averaged Index (12-MTA) or the COFI (Cost of Funds Index)
- The rate you pay is the Index plus the margin that you negotiate at closing. This margin varies from 1.75% to 3%
- Should rates return to the awful early 80's where rates were in the high teens, your rate can never go above 9.95%.
If you are an active investor, there are no other programs that can compare with the flexibility of this mortgage when it comes to investing your money and leveraging your home's equity for making more money with what you have. The Option ARM is a wonderful product for those wishing to invest what would be going to principle on their home in other faster growing retirement funds.
The MTA Option ARM is also valuable for borrowers who have variable income during the year or get a lump sum bonus at the end of the year as they can make just the minimum payment during their low income months and pay extra in the months of higher income or when the lump sum bonus arrives. Commissioned borrowers and Self-Employed business owners will benefit most from this program.
Before you read any further, please understand that this is NOT a mortgage for someone who just wants to pay off their house or is on a low income or only intends on making the minimum payment in order to save some money each month! There are other programs which are much better suited to those borrowers than this one.
How it Works
Every month when your statement arrives, you just check the box on the payment you would like to make this month and send in that amount.
There are 4 choices available:
1) A Minimum Payment
2) An Interest Only Payment
3) A 15 year Payment
4) A 30 year Payment (or a 40 year payment)
Two Different Interest Rates are used to compute your choices.
The minimum payment comes at a low start rate of 1.25% or 2.25%, while the other 3 choices are based on the 1 month treasury 12 Month Average plus your negotiated margin.
The Start Rate
The start rate increases 7.5% each year you have the loan. No, not 7.5% in interest rate, but 7.5% of your payment. In other words, if your minimum payment is $1,000 the first year, your minimum payment in year 2 would be $1,075, $1,155.63 in year 3 and so on...
This very low interest rate allows allow the savvy investor to put the money that would otherwise go to principle to work for them in making even more money.
Borrowers with variable income can use the minimum payment from the start rate to make smaller payments in months with lower income and then make larger payments in months with larger income or when the bonuses arrive so that the average is equal to making a 30 year payment.
However, the start rate is NOT the rate that interest on the loan is computed and making only minimum payments can lead to a negative amortization situation where you could owe more on the home than it is worth. This is not a loan meant to make only minimum payments unless the value of your home is going up faster than the balance of your loan.
This is discussed in more detail in
Part 4: How the Negative Amortization can be used to your Advantage
The ARM Interest Rate
As noted above, this interest rate is what will apply to your Interest Only, 15 year and 30 year payment options. This interest changes every month and is computed from your margin plus the index rate.
The margin ranges from 1.75% up to 3% depending upon your credit, points you have paid and your mortgage professional. For instance, , if the MTA is at 3.00%, your interest rate would be anywhere from 4.75% up to 6.00%.
Unless you will only keep this mortgage for a year or two (and maybe even then), I would strongly suggest that you pay points to get the lowest possible margin available to you. Call or email for info for what those points would be depending upon your loan amount and credit rating.
On a historical basis, although the rates for the MTA have been very low over the past couple of years and many look at this loan as one in which rates will only go higher and higher, over the past 15 years, the average rate has been below 6%. In fact only once since 1990 has the index been above 6.1%.
You can see all the monthly rates since 1953 at the Federal Reserve at this page
Due to the 12 month average being used to determine the interest rate, the rate moves up or down very slowly compared to a regular ARM giving you plenty of time to react and prepare for either higher payments of to refinance into a fixed rate mortgage.
If you have paid the points as suggested to get a low margin of about 2%, you can expect that your average interest rate on this loan will be in the 6 - 7% range over the long run. Very similar to a good rate on a 30 year fixed.
Why take this Option ARM?
Obviously, the question becomes why would you want to take a mortgage that has an average rate of 6 to 7% over the last 15 years if you can just get a 30 year fixed at the same or lower rate and not have to worry about the fluctuations and the answer lies in the minimum payment option.
I get a little more in detail about the advantages in part 3 and part 4 of this section, but this mortgage is all about flexibility and how you use the additional funds at your disposal by leveraging the equity in your home without having to take out home equity loans to have access to the extra money.
A home is what they call a "use" asset. In other words, you get the most value out of your house from using it, not from the increase in value. A home will increase from 2%-6% per year on the average, but a good investment will make you 10% - 15% per year.
The Option ARM gives you the opportunity to leverage your investment to buy a home to live in and get the "use" out of it plus put the money in a good investment at the same time.
Summary
The Option ARM is a very powerful tool for saving money, investing money and leveraging your home's equity to make more money with what you already have.
However, as with anything powerful, when not used correctly it can be very costly as well.
IF you use the mortgage and house as an interest deduction on your taxes and
IF you can make more money on an investment than it costs to access the money with this mortgage
IF your house is increasing in value or at least staying steady
this is a mortgage to seriously consider.
IF making interest only payments is just a way to have a lower payment
IF you have a high debt load
IF you have steady income with a paycheck or salary
IF house prices in your area may be on a bubble or have risen unreasonably and may drop back down
this is not the loan for you, you are better off with a mortgage with an interest only option
As always, the very best solution is to get an honest mortgage professional who will truly do the best thing for you. These professionals know that they will make more money off of the good referrals than they will ever make off of getting you to refinance again and again!
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Harry
Smith
email Harry@dailyinterest.com or reach me by phone Office 1-248-548-7655 Cell 1-248-514-9000 |
Drew
Smith
email drew@dailyinterest.com or reach me by phone Office 1-248-548-7655 Cell 1-248-703-7770 |
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Option ARM Mortgage - what it is and how it works at DailyInterest.com