Option ARM's

Various borrowers are asking about the implications of Pay Option ARM loans: "What is an Option ARM?" "How exactly does it work?" "What is a re-cast?" "Can I refi into another loan?" "What do I do If I can't get out of the Option ARM?"

To start off, a "Negative Amortization" loan is the same as a "Pay Option ARM". The lending industry changed the name to avert the focus from the potential for negative amortization to the benefits of payment flexibility. The late 1980's and early 1990's put a bad spin on the "neg am" loan. Thus, the "Pay Option ARM" was born! I have seen new, more exotic, products entering the market of late, but I will explain the basic neg am loan, as it has been structured over the past several years.

The basic gist of the Pay Option ARM is that the borrower is given three to four payment options for their loan: 1) Minimum payment 2) Interest-only payment 3) 30-year fully-amortized payment, and sometimes, 4) 15-year fully-amortized payment. I will be addressing the the "minimum" payment and its resulting "negative amortization". FYI: The minimum rate can vary a bit and some neg am's may offer a 40-year payment amortization options (as opposed to the 30-year option).

The minimum payment is calculated by taking a low "start rate" (usually 1%) and calculating a fully-amortizing payment (30 years). Thus, the borrower's minimum payment is like that of a 30 year, 1% , fully-amortized loan. However, the "accrual" rate is the rate that the borrower is actually being charged (ie: 7.5%, adjustable, although some can be fixed). Thus, on a $500,000.00 loan, the minimum payment is $1,601.20; the interest-only payment is $3,125.00; the 30-year, fully amortized payment is $3,496.07; and, the 15-year, fully amortized payment is $4,635.06. Thus, the difference between the minimum and the interest-only payment, $1,516.80, is added to the principal every time the minimum payment option is used. There is a little feature in the neg am loan that increases the minimum payment 7.5% per year (not the interest rate!), thereby slowing the negative amortization a bit.

Depending on the lender, occupancy status, etc., the lender will allow the borrower to accrue the extra principal until the loan hits a "cap" of 110%, 115%, 0r 125% of the original loan balance. Upon hitting the cap, the loan "re-casts". Thus, a borrower may end up owing $625,000.00 ($500k x 125%) on his original $500,000.00 loan. The speed at which this happens largely depends on the fluctuations of the accrual rate and how often the borrower chooses to make the minimum payment. If the loan "caps-out", then the lender re-casts the loan and will suspend the minimum and interest-only payment options (although, some will allow the borrower to continue making the interest-only payment). Thus, leaving only the fully amortized payment option. $625k at 7.5% x 25 (remaining years) = $4618.69, assuming the adjustable rate is at 7.5%. FYI: The interest rate caps on neg am's are generally 9.95 to 11.95%. Another feature on the neg am is that the loan will re-cast when the loan amount caps or at 61 months, whichever occurs first. For the borrower who has been making the minimum payment, this new payment can be crippling.

The neg am loan is a great loan for the appropriate borrowers: those who are in need of flexibility, are financially savvy, are looking for leverage, or are in need of bridge financing, are investors maximizing cash-flow, etc. There are many borrowers, over many years, who have benefited from this loan.

There are, however, many borrowers who are staring down the barrel of a large payment. What can they do?

Can they refinance? Yes. if the borrower has enough equity (<80%>700), adequate income, adequate assets, refi away! A borrower might want to refi, if they qualify, before values deteriorate any more (I predict that values will continue to drop). Otherwise, they may find that they cannot get out of the loan because their LTV may be over 80%. Many borrowers, with low LTV's and sufficient income, may opt to stay put and enjoy the flexibility of this loan until it re-casts.

For those borrowers who know trouble is coming(upside down and not enough income) , but they are not near their caps and they have time on their side, they can sit-it-out and hope for values to improve or their paychecks to grow! In the meantime, they are keeping a roof over their heads and tax deductions. The inevitable foreclosure or short-sale, however, may be at the end of the tunnel.

If you are one of those borrowers who has re-cast (or is about to re-cast), who cannot afford the re-cast payment and/or does not have enough equity to refinance, you might want to call your lender and let them know you foresee problems ahead. Many lenders are being forced to be more flexible in an effort to avoid a huge book of REO's (real estate owned= properties they took back). You might be able to re-negotiate your loan, get a note modification or arrange a "short sale". The aforesaid process is called "Loss Mitigation". A MortgageMaster will try and address this process in a later article.

I hope this information is useful. If you have any further questions, please e-mail TotalMortgageAdvice@gmail.com


MortgageMaster