There has been quite a bit of material written about the sinister mortgage programs called Option ARM’s, or fixed payment mortgages. Dangerous, Predatory, Deceptive, ______ fill in the blank with your “watch out!” comment of choice. The general consensus on how these programs hurt borrowers is getting to be a little much and beginning to bother me.
Option ARM’s (and other fixed payment mortgages) are fantastic if implemented correctly. There is plenty of literature out there on how Option ARM’s work, calculators, the negative amortization ability etc. So, this post deals with the main caveat when considering one of these exotic mortgages, which is directly related to how brokers (silently) make their money on these programs as well as what borrower and property types Option ARM’s are designed for.
Never, ever, finance a property with an Option ARM, based solely on the Minimum Payment Option as the means to affording the home.
For this post, we shall concentrate solely on the Interest Only (IO) Payment Option for this class of loans, since this is where the magic happens or all goes to hell in a handbasket. Pop a Ritalin and pay attention, then go back and read this section again.
Payment Option 2, The Interest Only Payment. The Interest Only (IO) payment is determined by adding an Index (I) to a Margin (M) to yield a Fully Indexed Interest Rate (FIR), or I% + M% = FIR%, or 4% + 2.5% = 6.5%. Never mind what the literal definition of Index and Margin are for now, just understand that the I and the base M are set by the lender according to borrower specific criteria (credit score, property use, LTV, etc).
The Fully Indexed Rate is the rate to be concerned with. Why? This is the interest rate that determines how much interest you can negatively amortize (if you make the Minimum Payment) and represents what the loan is truly costing compared to other types of mortgages. BEWARE!!! The base Margin can be adjusted by the Broker to generate excess YSP for their unjust enrichment. For Example:
The Program uses the MTA Index, which is (hypothetically) 4.2%. The borrower qualifies for a 2.5% Margin. This yields a 6.7% FIR (4.2% + 2.5% = 6.7%), BUT The Lender pays YSP to the broker/banker if the Margin is increased above par (in this case 2.5%) , so if the Broker bumps up the M to 3.5% (from the par margin of 2.5%), the FIR now equals 7.7% (4.2% + 3.5% = 7.7%). The broker would get paid a few thousand bucks (depending on the loan amount) to do so.
This is where borrowers can get in trouble if they don’t pay close attention. Brokers will sell clients on the low Minimum Payment while ’silently’ increasing the margin to yield a monthly interest deferment equal to another small mortgage. Generally, Option (and other fixed payment) ARM’s are best suited for:
- Those who can understand and explain the nuances outlined above.
- Property with excess equity (20%+ preferred)
- Loan Amounts above $200k.
- NOO/investment property, where the Minimum Payment is used to generate more cash-flow, or during times of vacancy to minimize the monthly liability
- Locations with appreciation anomaly factors (Coastal/Waterfront, new development, etc)
The name of the game when dealing with exotic mortgage programs is education. Ask questions and more questions. If it still doesn’t make sense, the program is probably not for you.
