Not a Good Option

Yesterday, one of my clients asked me about Pay Option ARMs.   These loans are Mpj034192600001_1 probably the most heavily advertised products promoted on the radio.   I cringe every time I hear the announcer boast about the low start rates of anywhere from 1 – 3%.  Pay Option ARMs are marketed by many different names, such as pick-a-payment or cash flow ARMs.   

A newer Option ARM program features a fixed period for the minimum payment and a fixed rate for a five year term.    Every month, when the mortgage payment is due, the borrower has the choice of what kind of payment they would like to make typically based on four different selections. 

Here’s an example of what a fixed period Option ARM could look like.

Option 1:  Minimum Payment–an interest only payment at 3% under the note rate available for the first five years of the loan (NEGATIVE AMORTIZATION).

Option 2:  Interest Only–an interest only payment based on the note rate available for the first 10 years of the loan term.

Option 3:  30 Year or 40 Year Fixed–A full principle and interest payment amortized over either a 30 or 40 year term.

Option 4:  15 Year Fixed–A full principle and interest payment over a 15 year term.

Sounds great, right?  Wrong.  I know a lot of lenders offer this product.  And, at least this option ARM offers a controlled minimum payment for a five year term.  However, how many people are going to make a principle and interest payment when they receive their mortgage coupon? 

Negative Amortization (deferred interest is the nicer term) is the difference between your note rate payment (the actual payment due) and the minimum payment (the low teaser rate).   In this case, every time you opt to make the lower payment, the difference is tacked on to your mortgage balance.   There are ceilings in place that will prevent all of your equity from being gobbled up from your mortgage called “negative amortization cap”.   This loan particular program (option ARMs vary from lender to lender, and this is just one that we could offer, if I don’t persuade you otherwise) features a cap of 115%.    This means that once you’ve made minimum payments long enough to increase your original mortgage balance by 15%, your loan terms will change and you no longer have the minimum payment available as one of your options (this is referred to as “recasting”).

Option ARMs can also impact your credit scores for the worse.   Credit scoring modules give more favorable scores when balances are decreasing and worsen if balances are shown above the credit limit.   If your original mortgage is $200,000 and due to negative amortization, the current balance is $215,000 (for example) your credit scores will be dinged as it appears to the scoring system that you’ve extended beyond over your credit limit on your mortgage.

These loans may work for seasoned investors who do not plan on utilizing the minimum payment option unless, perhaps, they have a rental without a tenant.     However, the majority of homeowners who have Option ARMs don’t fully understand how this animal works or that they are trading equity for lower payments until it sneaks up on them.  It’s not a program that I recommend for my clients when there are so many better programs available that won’t jeopardize home equity.


  1. John Mc Neil says

    I find your comments, as most of the negative comments towards Option Arms ignorant to the actual dynamics of the loan. First, my bank is the only bank who actualy has the pick-a-payment loan. You mentioned a 115% Neg Am cap on the Pick-a-Payment. Not only is that incorrect (it is 125%) but you also failed to recognize that the World Savings/ Wachovia pick-a-payment has NEVER exceeeded it’s cap. Why? We do not attach out ARM to a volotile index.Our Index is our own which is what we pay our CD customers over a 12 month rolling average. Ever hear anyone complain about the risk involved in CD’s? You also don’t take into consideration the borrower who only pays the 1% without paying off debt or investing the difference, would be using their credit card more without the cashflow allowed with a “Negative Amortization” loan. So not only is that minimum payment option an OPTION for the borrower, but also a TAX DEDUCTABLE alternative to borrowers who like to “Neg Am” with their credit cards. Most importantly it’s a tool for savvy investors that like to use the cash flow to invest in a plethora of areas, such as their childrens college, their own retirement (401k or IRA),or using the 1% option to pay off their 20% credit card debt. It is the volatility of indicies such as MTA or LIBOR that should scare people into not taking an ARM right now. The World Savings Pick-a-payment doesn’t fall into that category. Maybe you should do some research on it before you throw us all into one category. We also have a new 30 year fixed pick-a-payment which I would bet a dolar you know nothing about.

  2. John, you are NOT the only bank who offers a pick-a-payment loan. I’m not sure where you’re coming from with that or why you think you have the corner on the market with that program.

    My post states that this is not a good tool for most consumers and that it may work for some.

  3. Jose Vasquez says

    John and Rhonda,

    I agree with both of your points to a degree. However I’m more in John’s camp in regards to Option Arms/Pick a payment loans.

    I’ve been doing loans for 15 years and my business is 20% fixed/ 30 % intermediate arms/ and 50% option arms. I know this product inside and out.

    I agree with Rhonda that I cringe at how they’re advertised sometimes. However I don’t think we should dismiss this loan as a useful financial tool in the hands of the educated home owner or investor. Not fully explaining the product is misleading and has caused a lot of harm. However in all fairness I’ve had customers complain about intereste only loans in which they were misled to believe that the minimum payment would pay down the principal.

    However I agree with John that right now in this market they are a very effective tool give today’s interest rate market. For the record Wachovia is not the only lender doing these loans; there are a couple of other lenders doing them as well but only a few…. of which Wachovia is the biggest bank out there doing them with the one of the lowest start rates. Banks simply don’t want to do them mainly because they cannot be sold on the secondary market and in cases that they can be sold their return is only about 20 bps!! That’s why they’re restricted their guidelines and increased start rate pricing on them.

    They only banks that can do them at the lower start rates are true portfolio lenders (ie. Wachovia, Dowey Savings, etc).

    In my experience with this loan is that it’s great for someone that wants cash flow and they have a very comfortable equity position on their house so the neg am amount is not a signicant dent on their equity. My typical borrower is very saavy and knows all the options out there however he realizes that paying down a mortgage is a bad investment given other uses for this money. My average loan amount on these has been from 600k to 1.8 million with typical ltv from 30-70%. I have clients who live in affluent areas where values have stayed steady or even gone up in this market due to desirability of their neighborhoods.

    Also, step back and look at the big picture…what’s happening with all indexes now? They’re free falling given current treasury yields, prime, and cd rates. Yes John is correct that other indices such as the mta may be more volatile so cofi and cosi indices based on cd’s etc may be more stable. This downward movement means that neg am amounts are going down!! Do any of you remember what happened in 2003 with the cofi and mta option arm loans? The fully indexed rate was so low at around 4% that the 1% minimum payment actually paid down some of the principal!!

    So before making broad statements about what may work for most consumers…some actual data need regarding their equity and total financial plan needs to be brought in as back up data..

  4. Jose, I’ve always said there are no “bad mortgages”–there is bad advise, bad planning (or lack of planning), bad LO’s…

    I’ve found with my clients that when they understand how an option ARM works, they would rather opt for a long term interest only ARM.

    I will admit that I am biased against this product because of how I’ve seen it misused.

    And I’ll stick to my guns that for a majority of home owners, this is probably not the product for them. I feel it’s better used with an investment property.

    Thanks for visiting Mortgage Porter and your comment.

  5. Looks like Wachovia agrees this is no longer a good option…they are no longer offering option ARMS and it’s my understanding they are waiving prepayment penalties.

  6. Congrats to Rhonda for being early on this one. Definitely keep this post up. It is valuable to see how these loans were justified at the time. Most interesting is the people selling these loans really didn’t have bad intentions. They were trying to help their clients and relied on historical data that didn’t represent future trends in the housing market.

  7. PM, I’ll always say there are no bad mortgages, just bad advice (or lack of any). These mortgages were used by the wrong people for the wrong reason. Lenders should not have advertised the low teaser (negative amoritzed) rates to borrowers…and borrowers should have asked more questions. Ah..but I’m full of “shoulds” now.

    I’m glad I stayed away from options ARMs and really just did a few stated (never OVER-stated) loans as well…another mis-used program.

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