Although option arm (or pay option arm) loan programs can provide
many benefits for a large group of homeowners they are not
without risk. Interest rates have been low for a very long
time but eventually they will rise so if you are a first time
homeowner or a consumer with limited or fixed income then it
is wise to understand the following risks before accepting
an option arm home loan.
loans carry the possibility of Negative Amortization
arises when the mortgage payment is smaller than the interest
due causing your loan balance to increase rather than decrease.
Much like a credit card if you only pay the minimum due you will
most likely never see your principal balance decrease however
there is also greater risk that your loan balance will grow the
longer you simply pay the minimum due.
Can you end up owing more than your original loan amount?
Yes. Absolutely, Positively Yes.
Option arm loans provide
homeowners with payment options (hence the name). One of
your payment options
will include a minimum payment amount that is lower than the
actual interest owed. Should a homeowner choose to
pay the lowest amount then the remaining interest will simply be
added to the principal balance (negative amortization). Ask your loan officer
for a copy of the note before signing any documents. You
will usually see a clause stating in the event your mortgage
balance increases above 110-125% of the initial mortgage amount
the lender will have the right to recast your payments or force a principal payment in
order to maintain the balance below this limit. The
following information will help you understand how the payment
recasting process applies.
Negative Amortization Cap:
This cap limits the loss of equity in
your home when your monthly payments are not sufficient to
cover the fully indexed interest rate charges agreed upon in
terms of your mortgage note. This amortization cap is
usually set to either 110% - 125% of your original principal
balance. When the negative amortization cap is
reached, the minimum
payment increases immediately and the payment
required to fully
amortize the loan over the remaining term becomes the new
minimum payment. Additionally, the safety of the payment cap
will no longer apply.
Payment Recasting (another way of
simply saying re-calculating your loan payment)
is a lenders way of limiting negative amortization and
keeping your loan on the original payment schedule.
Option ARM and Pay Option Arm loans are recast every five
years (or sooner, if the negative amortization limit is
reached). Your new payment will be based on the
outstanding principal balance, the remaining term and the
fully indexed rate according to your loan terms.
what about my
ability to obtain a home equity loan?
It's every homeowner's
responsibility to understand what lenders do at the time you
originate an "Option Arm" mortgage. Since your
minimum payment could be below the actual amount of interest you
owe lenders will secure a note on your home that is for more
than the face value of your loan in order to protect their
interest in the event your principal balance rises. For example, if you
are taking a mortgage out for 80% of a $200,000 home your loan
will be for $160,000 however the lender may secure up to
$160,000 X 1.25% or $200,000 of your equity. Therefore
some lenders may consider this first mortgage as counting for
100% Loan to Value making it tougher to get a home equity
are interested in obtaining a second mortgage or a home
equity line it may be difficult unless you
have a reasonable amount of equity in the home. Most
lenders who review your second mortgage application will
consider your first mortgage balance plus the additional 25% in
order to count for the first mortgage lenders rights. It
is possible to get a second mortgage behind these loans but
terms can be difficult and lenders hard to find if you already
owe above 90% of your home's value. Of
course, if you have 50% equity then your options will be much
stronger however for first time homebuyers with minimal down payments it may
very wise idea to consider other mortgage options before
the option arm loan.