Option ARM

Option ARMs are scary because monthly payments can stay low for a long time and
then suddenly go kerflooey. (Did I spell kerflooey right?)

Standard & Poor's is out today with a press release about a report that explains why
they tightened up their criteria for option ARMs, effective Aug 1. The report (which is
available under Ratings Criteria on the S&P website, fifth item down) explains why
S&P felt it necessary to assume higher foreclosure frequencies on option ARMs.

With an option ARM, you have the option to make a minimum payment that doesn't
even cover all the interest you owe, let alone any of the principal. The unpaid interest
gets added to the balance on the loan.

Annual caps on how much your payment can go up--typically 7.5%--give a false
sense of security. The caps are like keeping your thumb over the mouth of a bottle
while vigorously shaking it. Eventually, if you underpay what you owe for long
enough, the principal on your loan will breach a preset limit, which tends to be either
10% or 25% greater than the original amount borrowed. At that point, all caps are
blown off and the monthly payment jumps all the way up to whatever is required to
fully amortize the loan over its remaining life.

Example given by S&P: The monthly payment goes up between month 48 and month
49 by 88%. On a $500,000 loan, using S&P's assumptions and my multiplying skills
from fifth grade, that would be as follows:

Month 1: $1,665
Month 48: $2,070
Month 49: $3,900

"Payment shock" is what S&P calls this. Here's an understated quote from the S&P
analysts:

... some of the borrowers may not have the financial wherewithal or the financial
savvy to absorb or plan for sudden jumps in monthly payments.

Correct. Are mortgage brokers and lenders making the risks crystal-clear to all the
people who are signing up for option ARMs because they're attracted by that low, low
initial payment?

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 What Is an Option ARM?

It is an ARM on which the interest rate adjusts monthly and the payment adjusts
annually, with borrowers offered options on how large a payment they will make. The
options include interest-only, and a "minimum" payment that may be less than the
interest-only payment. The minimum payment option results in a growing loan
balance, termed "negative amortization".

How Will I Know an Option ARM When I See One?

Ask the loan provider if the rate adjusts monthly, and if negative amortization is
allowed. If the answer to both questions is "yes", you almost certainly have an
FPARM. Their names are all over the lot and include "1 Month Option Arm", "12 MTA
Pay Option ARM," "Pick a Payment Loan", "1-Month MTA", "Cash Flow Option Loan",
and "Pay Option ARM".

What Are the Advantages of an Option ARM?

Their main selling point is the low minimum payment in year 1. It is calculated at the
interest rate in month 1, which can be as low as 1%, and it rises by only 7.5 % a
year for some years.

The low initial payment entices some borrowers into buying more costly houses than
would have otherwise, or use the monthly payment savings for other purposes. You
don’t need a list from me of ways to use the cash flow savings because your loan
provider is sure to oblige. What they are less likely to give you is a sense of the risks
you will face down the road.

What’s Are the Risks of an Option ARM?

For those electing the minimum payment option, the major risk is "payment shock" –
a sudden and sharp increase in the payment for which they are not prepared.

The rule that the minimum payment can rise by no more than 7.5% a year has two
exceptions. The first is that every 5 or 10 years the payment must be "recast" to
become fully-amortizing. It is raised to the amount that will pay off the loan within
the remaining term at the then current interest rate – regardless of how large an
increase in payment is required.

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The second exception is that the loan balance cannot exceed a negative amortization
maximum, which can range from 110% to 125% of the original loan balance. If the
balance hits the negative amortization maximum, which can happen before 5 years
have elapsed if interest rtes have gone up, the payment is immediately raised to the
fully amortizing level.

Either the recast provision or the negative amortization cap can result in serious
payment shock.

How Do I Protect Myself Against The Risks?

Three ways:

1. Measure the Risk: You can do this yourself using calculator 7ci. It will show you
what will happen to the payment on your FPARM if interest rates follow any of a
number of future scenarios selected by you. An important side benefit is that the
calculator lists the information you need, which you want for shopping purposes
anyway.

2. Minimize the Risk by Shopping For the Lowest Margin. The margin on your loan is
the amount added to the interest rate index to get your rate. Since the margin
affects the rate in months 2-360, it is the most critical price variable on an FPARM.
The lower the margin, the lower your cost and your vulnerability to payment shock.
Note: The margin is not a required disclosure, so don’t expect that it will necessarily
be volunteered.

3. Minimize the Risk by Taking the Highest Initial Payment You Can Afford. The
higher your initial payment, the smaller the potential payment shock down the road.
Since the initial payment is determined by the interest rate in month 1, you should
select the highest rate that results in a payment with which you are comfortable.
Asking for a higher rate sounds a little strange, but remember, the quoted rate holds
only for one month.

Who Should Take an Option ARM?

Choose one if your time horizon is short and you want to maximize your home-
buying capacity. Because of their low initial rates and payments, borrowers can
usually qualify for a larger loan using an option ARM. Since payments will be
substantially higher in later years, you should confidently expect your income to rise
in the future. The option ARM is also a refinance option if your income has dropped
and the alternative to lower payments is default. I do not advise using this
instrument to generate cash flow savings to invest, see Is Unused Home Equity a
Missed Fortune?

Should I Shop For An Option ARM?

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Yes, emphatically, but not for the rate. Your major focus should be on the margin,
because that is what determines your rate after the first month. Your second priority
should be the maximum rate. Your third priority should be total lender fees.

The good news about monthly ARMs is that lenders don’t reprice them every day as
they do other mortgages, which makes comparison shopping much easier. You don’t
need a rate lock, but ask the loan provider to specify the margin, maximum rate and
fees on paper.

Cut your monthly payments by 45%! Finance $300,000 for under $1000 per month!
Interest rates as low as 1%! Call today!"

Are you tempted by the siren song of low, low monthly payments? Do you get eye
strain from trying to read the fine print flying by on the screen, only to be confused
as to what it says? You're not alone. There are many thousands of people just like
you, many of whom who already have selected a loan which not only allows for but
guarantees rising loan balances and monthly payments in the years ahead.

This article will help you understand the pervasive effects of negative amortization,
and may help you to decide whether a "minimum payment" mortgage is to your
maximum benefit.

What is an Option ARM or Pay Option ARM? Simply, it's a mortgage loan which allows
you a choice of payment methods: fully amortizing over 30 years, fully amortizing
over 15 years, interest-only payments, or a payment based on a below-market
"payment rate" which fails to cover even the interest which is due. In such an
arrangement, the differential between what you actually owe and what you are
paying is added onto the outstanding loan balance each month, a condition known as
"negative amortization."

A negative amortization mortgage isn't something that most people would ask for by
name, but they can be attracted to ultra-cheap monthly payments. Call them what
you will -- "Option ARM", "PayOption ARM", "Pick-a-Payment", "Cash-flow ARM", or
other descriptive term -- one thing is certain: these products all feature a payment
method where the interest you pay is based on an artificially low contrived interest
rate based not on market conditions, but on nothing more than a lender's marketing
ability.

These ARMs may also offer interest-only payment methods. For details on how those
work, see our article "The Principal Facts of Interest-Only Mortgages".

A Little History

Loans which allow for negative amortization aren't new; they date back to mid-
1980s, when fixed rate mortgages were in the uncomfortably high 9%-10% range.
ARMs based upon the 11th District Cost of Funds Index, or COFI ("coffee" ARMs)
were available at comparably attractive initial rates around 7%, and featured new
and novel ideas like annual "payment caps" instead of per-adjustment interest rate

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limits each year. In fact, payment caps were actually a selling point at the time, when
interest rates were considerably more volatile than today: payment caps promised
some budgetary peace of mind because no matter what happened to rates, your
required payment would rise only a little from year to year.

ARMs in general were still fairly new on the scene and not well understood. Many
borrowers found out too late that, unlike rate-capped ARMs (where any charges due
to interest rate changes in excess of two percentage points were absorbed by the
lender), pay-capped ARMs took the difference between what you were paying and
what you actually should have been paying, and added it back onto the loan balance.
Worse yet, borrowers took these ARMs just before a considerable rise in the COFI
which took that index from the low 7% range to nearly 9%. After margins were
added, the interest rates on those loans -- which started in the sixes -- climbed to
around 11%.

Between an ever-rising loan balance and what seemed to be ever-rising interest

rates, many borrowers found themselves in trouble. That was even before property
prices in many areas began to fall, leaving more than a few borrowers with negative
equity: their loan balance was higher than the home's resale value. These
'underwater' borrowers found that selling their homes still left them with a
sometimes sizable debt.

Today's Differences

Unlike those 1980s experiences, where those loans inadvertently became negatively-
amortizing due largely to market conditions, today's loans have a different twist:
They begin in a neg-am situation, where a rising loan balance is guaranteed. Rather
than the interest rate starting at market rates and perhaps rising over time (while the
borrower has opted to make only a limited payment), these products come out of the
box with a "payment interest rate" well below what is actually being charged. As a
result, the loan balance starts to increase right away. This chart shows how the gap
between the interest rate you are being charged and the interest rate you are paying
starts pretty wide, but has then gotten wider over time.

About the Accompanying Charts

For these charts, we made what we think are realistic assumptions. First, we
started with a one-month LIBOR-based option-style ARM in June 2003 with a
minimum payment rate of 1.5%. Then, we followed the actual trajectory of
interest rates from 2003 to May 2005. From there, we assumed that LIBOR (like
other short-term interest rates) would rise a total of 0.75% over the next 12
months, then level off and hold steady for the next year after that. Most likely, the
change to underlying interest rates won't be quite as smooth; the increase may
be more or less than 0.75% over the next year, or rates may not hold steady after
that. However, it's useful to know that over the last ten years, the average for the
one-month LIBOR has been 4.119%, and our example never even gets as high as
"average".

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 August 2006 Update:
As it turns out, our working estimate from May 2005 was far below the actual
trajectory for interest rates. In the original article, the highest actual index rate
we used was 3.1126%, and we figured that LIBOR would climb up to 3.8626%
over the next year. However, by the August 2006 update, LIBOR stood at
5.4045%, with our loan's interest rate well into the mid 7% range. The excess
increase in rates means that negative amortization rose more quickly and over a
longer period, and the mortgage holder would now have almost no equity leftover
after the home is sold. The charts now show our original estimates and the
updates. Go to the charts

Even though these loans are intended to be easy on the monthly budget, the
guaranteed steady 7.5% increase in your required payment each year will also begin
to crimp your flexibility over time. If you're considering using one of these payment
methods, you'll need to be aware that the initially-low monthly payment won't last,
and that you will have to plan for higher payments accordingly.

You should also be aware that starting with a big gap in the payment stream
produces a loan balance which grows more quickly than one which starts with an
almost-fully-amortizing interest rate. That payment differential will grow as long as
the loan balance continues to increase, exacerbated by increases in interest rates,
demonstrated here. As well, that payment gap is only temporarily narrowed by the
annual increases of 7.5% in the required payment amount, then continues to press
upward as the loan balance and interest rate grows.

Rates steady, Due Payments Rising?

Unless the rate of interest at which you are making payments quickly approaches the
rate you are being charged, it's a certainty that the monthly payments you actually
owe will rise, even if the actual interest rate you are being charged doesn't. The
reason is due to your ever-increasing loan balance, which requires a higher monthly
payment (if only slightly) to cover the interest and principle which is actually due. In
fact, our chart shows this fairly clearly; despite the "actual interest rate" holding
steady during the final 17 months of the chart, the actual payment due continues to
creep higher, rising by a total of over $30 per month during that time. Due to this,
even if the your "actual interest rate" should decline somewhat, your "actual due
payment" payment may not decline, but simply flatten out over time.

Protection and "Recast Triggers"

While these monthly neg-am ARMs do have some limits on how high your interest
rate (and subsequent required payment) can rise, those ceilings are typically in the
9% - 10% range. If you've become accustomed to making payments well below that,
you could find financial trouble when your rate gets recast.

Early neg-am ARMs typically had just one recast trigger, where your monthly
payment was adjusted from the limited payment to one which was fully-amortizing.
That normally occurred when the loan balance climbed, through negative

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amortization, to 115% or even 120% of the original loan amount. Even with rising
rates and rising loan balances, it could take a long time to get to those triggers, but
letting a deferment in payment build into potential catastrophic increase over a
period of years (only to find that the borrower couldn't manage it) wasn't a prudent
lending strategy. This time around, though, lenders have developed a slightly
different strategy which provides them a little more protection.

A secondary, regularly-scheduled recast of your monthly payment is one of the newer

wrinkles found in some of today's neg-am ARMs. At a set interval, usually five years,
the lender will adjust your monthly payment to be fully reflective of the remaining
balance at today's market interest rate. This could cause a measurable increase in
your monthly payment, so you need to be prepared for it. As well, the old 120% or
115% triggers have been lowered, with many contracts allowing for "only" a 110%
recast trigger.

Hitting a Trigger

It's considerably easier to hit a 110% trigger than a 120% trigger, but coupled with a
5-year recast it's safe to say that your payment will be rising fairly soon, regardless
of the way you hit a given trigger. In fact, our example chart, using our assumptions,
puts your outstanding loan balance at the 110% trigger at about the 51st payment --
just over four years down the road. Should that happen, your monthly payment will
rise from its "limited" $460.90 per month to $710.26 per month -- a $250 per month
kicker (with an original $100,000 loan amount) -- and that 54% increase in your
monthly payment might be difficult for you to manage.

The Equity Gap

Of course, the risks of negative amortization isn't simply that your loan balance
increases over time, or that you could face staggering rises in your monthly payment.
There can be additional risks, especially when property prices fail to increase or
increase only slightly over time (admittedly not today's problem, but no one really
knows what market conditions lie ahead in the next few years). In such a situation,
the property's value may increase only slightly over time, while your loan balance is
increasing, too. This means that you aren't building much -- if any -- equity, which
could be an issue should you want to sell your home (or refinance) down the road.

This is true even if you made a downpayment. If, for example, you bought a home
for $105,263 and made a 5% downpayment, your loan amount would be the
$100,000 found in our example. If property prices should increase at about the
inflation rate expected over the next four years -- a 3% annual increase -- the value
of the home would end up at $118,474 after four years. Now, typical sales
commissions for residential real estate are about 6% of the selling price, which would
subtract $7,108 from that gross total, leaving you with $111,366 after the disposition
of your home. However, since your loan balance has increased over that time, the
payoff of your loan (excluding any prepayment penalties) is $111,103 -- leaving you
with a grand total of $263 in "profit" after four years (not to mention the costs of
maintenance during that time). See this chart for a graphic description.

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It's not certain that property prices will increase or decrease over the next few years
(or by how much). One thing is certain, though -- your loan balance will have
increased. A lower rate of property price appreciation, no property price appreciation
or a downward adjustment in prices could leave you in a "negative equity" situation
pretty quickly, meaning that, if you still want or need to sell, you'll need to cover
some of those costs out-of-pocket.

The same caution goes is you should hope to refinance, as well. If property price
appreciation doesn't "go your way" over the next few years, you may have little
equity in your home, and could find it more difficult to refinance at terms favorable
enough to be valuable to you.

While there's nothing specifically wrong with accepting a loan which allows for
negative amortization, they aren't for everyone. Borrowers without 'liquid' asset
strength -- cash reserves which can be tapped as needed, especially when a recast
occurs -- may find themselves in a serious bind, so if you don't have ample reserves
at your disposal, you should use caution when considering a neg-am product.

We realize that at least some investor/speculator borrowers are using these products
because they prefer a low monthly mortgage carry cost, and hope to sell before the
rising cost of the debt and sales charges overwhelm the rising value of the property.
For some, this strategy has probably worked well, at least over the past few years,
when home values have leapt by 10% or more each year. However, we cannot stress
enough that "past returns are a poor indicator of future gains", and by no means is
equity growth a certainty... although a rising loan balance is.

A mortgage called the option ARM offers a tantalizing possibility: payments that are
so low, you can owe more on the house at the end of the month than at the
beginning.

Option adjustable-rate mortgages are appropriate for some borrowers in certain

circumstances, and they're dangerous for other people because of the danger of
falling too far into debt. A recent cover story in Business Week dubbed the option
ARMs "nightmare mortgages" and called them "toxic" and "deceptive."

If you have an option ARM, here are five warning signs that you are assuming a lot of
risk.

You don't understand how an option ARM works, but you have one anyway.

An option ARM is an adjustable-rate mortgage that gives the borrower four choices of
a payment each month. The borrower can pay the amount necessary to pay the loan
off in 15 years or in 30 years. The borrower can pay only the interest charged in the

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previous month. Or the borrower can make a minimum payment that doesn't cover
the interest, so the loan balance increases.

Most option ARMs have absurdly low introductory rates, sometimes below 2 percent,
that last just a month. Then they rise. And rise. The rate changes each month, but
the minimum required monthly payment changes only once a year.

"The thing no one realizes is, the rate is fixed for only 30 days," says Mitch Ohlbaum,
president of Legend Mortgage in Los Angeles. "The payment is fixed, and that's nice
-- but the rate isn't."

You exaggerated your income on your application. A lot of option-ARM

borrowers have stated-income loans, in which the lender doesn't verify the amount
that the borrower claims to earn. If you puffed up your income, you are more likely
to default.
You regularly have been making minimum payments -- not paying down your
debt and, in fact, increasing it. You feel this not only in your pocketbook, but in your
gut.

"It's a monthly toll," says Bob Moulton, president of Americana Mortgage, a

brokerage on Long Island, N.Y. He sees option-ARM borrowers "angst-ing over this
change happening each month."
You're approaching the principal cap.

When you make the minimum payment, and the loan balance increases, that
phenomenon is called "negative amortization."

Lenders set limits on how far negative amortization can go. Most option ARMs have a
principal cap of 110 percent, meaning that if your loan balance reaches 110 percent
of the initial loan amount, you'll suddenly have to start paying down the loan
balance.

Before you reach the principal cap, the minimum monthly payment can rise only a
maximum of 7.5 percent a year. After you reach the principal cap, that limitation is
thrown out the window. The minimum payment can more than double in some cases.

House prices in your neighborhood are falling. The danger with falling houses
prices is that you could end up owing more than the house is worth. That puts you in
a position where you can't afford to refinance the mortgage or sell the house unless
you have enough cash lying around to make up the difference. And if you have that
much cash, why are you in over your head with your mortgage?

"Basically, what you're going to have on a lot of those pay option ARMs, is you're
going to see a lot of customers giving the keys back," says Mark Lefanowicz,
president of E-Loan.

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To stay out of trouble, there are a number of things you can do if you have an option
ARM: Make at least the interest-only payment, refinance the loan or sell the house
and pay off the mortgage.

By making the interest-only payment, you're at least treading water instead of

sinking under the waves. You're not paying down principal, but you're not adding to
it, either.

But if you can't handle interest-only payments, it's time for Plan B: refinancing the
loan. Talk to your current loan servicer to find out if there's a prepayment penalty
and how much it would cost.

Then there's Plan C. That's when you recognize that you bought more house than you
can afford. The solution: Sell it.

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Negative Amortization

What is a Negative Amortization Mortgage?

A negative amortization mortgage is one, which has a low monthly payment that
does not entirely cover the accrued interest each month. Since the borrower is not
paying enough to cover the interest accruing on the loan, the difference between the
amount paid and the interest accrued each month is added to the balance of the
loan.

At first, the thought that your payment is not keeping up with the accruing interest,
can be a little unsettling. When folks do not understand things they tend to back off.
So, let's look at a negative amortization loan scenario.

Credit Score: 720 FICO

Occupancy: Owner Occupied
Doc Type: Stated Income / Verify Asset
Property Type: Single Family Residence
Purchase Price: $500,000
1st Mortgage: $400,000 (80%)

2nd HELOC*: $ 50,000 (10%)

1st Mortgage HELOC*

Start Rate: 1.000% 10.500%
Index (MTA/Prime): 3.618 7.250
Margin: 3.175 3.250
Maximum Balance: 110% $50,000
Payment
7.50% N/A
Adjustment CAP:
Interest Only
Amortization: 30-Years
10-Years

* HELOC: Home Equity Line of Credit

Start Rate versus Fully Indexed Rate

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IMPORTANT. It is paramount that you understand the difference between the "Start
Rate" and the "Fully Indexed Rate (FIR)" in relation to Option ARM loans.

• The Start Rate is merely a way to calculate your payment, it has no correlation
whatsoever to the actual interest rate of your loan.

• The Fully Indexed Rate is the actual rate that your loan accrues interest. It is
calculated by adding the current index (MTA in this case) to the margin. The
index changes monthly, up or down. The margin, which does not change, is
effectively the lender's 'gross profit' margin; what is left over after the lender
incurs the costs to do your loan and service it through the life of the loan is
their 'net profit.'

Guaranteed Payment Periods

Option ARM loans provide different guaranteed payment periods of 1-year, 3-years
and 5-years. The greater number of payment periods guaranteed, the higher the
margin, which is directly related to your effective interest rate, called the "fully
indexed rate." For Option ARM loans, only the payment is guaranteed, not the
interest rate unlike a 3-year or 5-year ARM where both the payment and interest rate
are guaranteed for the time period.

Maximum Balance

The Maximum Balance defined for the loan is either 110% or 125% depending on the
lender's risk level and what index they are using. Allowing your loan to grow to 125%
of the original balance being the riskier loan for the lender.

Payment Adjustment Cap

The Payment Adjustment Cap is the factor which is used to calculate your payment.
For the most part, the mortgage industry has standardized this factor to be 7.5%*.
In the case of a 1-month Option ARM, your initial payment is calculated based on a
1% start rate (for owner occupied) amortized over 30 or 40-year. This payment stays
the same for the initial 12-months at which time a new payment is calculated for the
next 12-months. The new payment is calculated by adding 7.5% to your current
payment. So, a $1,000 payment goes to a $1,075 starting month 13. After 24-
months have passed, the payment is recalculated for the next 12-months. This
process goes on until one of two things happen:

• 60-months have passed, or

• the loan balance has risen to 110% of the original loan amount.

As soon as one of these events occurs, the loan is "recast," which means that it is
amortized over the remaining life of the loan. At this point you start to pay the
deferred interest that has accrued (assuming that you paid the Minimum Payment),
and eventually the principal of the loan.

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* There are a few lenders that offer a start rate of 0.5% and increment the rate by
0.5% each year. This averages out to a Payment Adjustment Cap of 7.20% for a 30-
year amortized loan and 9.44% on a 40-year amortized loan for the initial 5-years.

Illustration

The scenario illustrated is the 1-month Monthly-Treasury-Average (MTA) Option ARM

with a 3-year prepay. A 3-year prepay period eliminates the need for the borrower to
pay any up-front points, and 3-years also coincides with changes in the loan, which
generally occur between the middle of the fourth year to the sixth year depending on
the movement of the index and the Maximum Balance that the lender has set.

In early 2005, the mortgage industry went to "hard" prepayment penalties for Option
ARM mortgage loans, which means that if you sell or refinance, you will incur a
prepayment penalty. Of course, you can "buy out" or "buy down" the prepay, but if
you want a no-point loan, a prepay is the trade-off. The penalty is 80% of 6-months
interest (80% because you are allowed to pay down 20% of the original loan balance
during the prepay period without penalty), and is calculated by taking the current
fully indexed rate and multiplying it by the original loan amount, dividing this number
by 2 and multiplying by 80%.

Note that our illustration assumes that the indexes do not change, which is an
unrealistic assumption but that is all we have to work with. Since borrowers generally
only hold these loans for 1 to 3 years, index movement is not a big issue with most
borrowers. Also, by using an index like the MTA (Monthly Treasury Average), which
averages the actual index over 12-months, you DO NOT get the volatility like you get
with the LIBOR (London Interbank Offered Rate) indexes, and others, which are not
averaged. See article on ARM Indexes.

Negative Amortization Analysis

Monthly Payments 1st Mortgage - Neg Am Calculations (annual)
Interest Int on Total
Mos 1st 2nd Total Only Min Pmt Accrued Accrued Accum
(A) (B) (C=A+B) (D) (E) (F=D-E) (G) (H=F+G)
12 $1,286.56 $437.50 $1,724.06 $27,172 $15,439 $11,733 $399 $12,132
12 $1,383.05 $437.50 $1,820.55 $27,172 $16,579 $10,575 $1,183 $23,891
12 $1,486.78 $437.50 $1,924.28 $27,172 $17,841 $9,331 $1,940 $35,161
6 $1,598.29 $437.50 $2,035.79 $13,586 $9,590 $3,996 $1,262 $40,419
78 $2,989.79 $437.50 $3,427.29
120

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The Maximum Balance (i.e. 110% of the original loan of $400,000) is reached after
42-months, assuming that you made the Minimum Payment for the entire period. The
figure $40,419 (column H) is 10.1% of $400,000, which means that your loan
balance after 42-months is $440,419, or 110.1% of the original loan amount. The
month that this occurs, your loan will convert to an amortized payment over there
remaining life of the loan. In this case the $440,419 will amortize over 26.5 years.

Why Negative Amortization Mortgages are NOT a Problem!!

Let's put negative amortization into perspective. The $40,419 represents the increase
in your mortgage balance for the 3.5 years. This means that your mortgage balance
grew 2.79% (exactly 2.78854%) per year. This also means that if your property is
increasing only by the inflation rate (i.e. 3% to 4%), you are NOT losing ground with
respect to equity. See table below.

Appreciation
Offset by Negative Amortization
Appreciation Average Average Accumulated
Rate per Month per Year 3.50 Years
3% $88 $1,060 $3,710
4% $512 $6,150 $21,524
5% $947 $11,366 $39,782
10% $3,285 $39,426 $137,991
15% $5,913 $70,955 $248,342
20% $8,850 $106,199 $371,696
25% $12,117 $145,409 $508,932
30% $15,737 $188,842 $660,946
40% $24,119 $289,426 $1,012,991

The table above tells us that if your property only increased each year by 3%, a small
equity of $3,710 is maintained. We have seen appreciation levels across many areas
of the USA for the past few years of 15% to 40% and more. Using a more
conservative number like 10% appreciation per year would yield about $39,426 per
year in equity buildup. Of course, to maintain the low Start Rate type payments you
would have to refinance every few years.

The ABSOLUTELY BIGGEST benefit of Option ARM loans is that the low payment gives
you the ability to control twice as much real estate versus traditional mortgages
especially with the 40-year Option ARM! Most investors refinance every 2-4 years to

14
not only pull cash out but also to reset their payment back to the low Start Rate
payment!!

15
 Option ARM - The World's Most Dangerous Mortgage

Home prices have reached record levels, and in many parts of the country, homes
have become nearly unaffordable. Real estate has replaced the tech stocks of the late
1990’s as the hot investment, and everyone has sold their stocks and jumped into
investment property. Real estate prices have increased at a far greater rate than
salaries, and the lending industry has attempted to solve this problem by introducing
a tremendous number of mortgage options for borrowers who barely capable of
purchasing a home. Most of these loan types feature adjustable interest rates and
minimum down payments. One of these, the option ARM, is the most dangerous type
of loan ever introduced. Borrowers who are considering an option ARM should be
aware that this loan could leave them with a loan that is worth far more than the
home it’s used to buy and with a loan that he or she cannot afford to pay. The option
ARM is not for the squeamish.

So what, exactly, is an option ARM? An option ARM is a mortgage with an adjustable

interest rate that typically gives the borrower four different payment choices each
month. The first choice is based on a 30-year amortization table; the second on a 15-
year amortization table. These would correspond to payments for adjustable-rate 30
and 15 year mortgages, respectively. The third choice is an interest-only payment,
which pays the interest that accrues during the month but pays nothing towards
reducing the loan amount. The fourth choice, the one that makes this loan so
dangerous, is called the “minimum payment.” The minimum payment is calculated
upon the first month’s interest rate, which is usually a very low “teaser” rate that can
be as low as 1-2%. Most borrowers with an option ARM opt to pay the minimum
payment each month, and that’s where the trouble comes in.

The loan carries and adjustable interest rate, and this rate can adjust as often as
every month. If the borrower is paying only the minimum payment, then he or she
isn’t even paying enough to cover that month’s interest on the loan. What happens
then? The unpaid interest that has accrued is added to the loan principal. The
principal can actually grow larger, and as interest due is calculated on the loan
principal, the interest due will increase, as well. Interest rates are currently near all-
time lows and are sure to increase. A buyer who continues to make minimum
payments on an option ARM will find that the principal on the loan is actually
increasing over time! This is known as negative amortization.

In a negative amortization situation, only bad things can happen. The lender can
require refinancing under certain conditions stated in the loan agreement. The buyer
may find himself unable to pay the loan and may have to default. And the lender
could find himself holding a note that is worth far more than the house that it
represents.

The option ARM is a loan that is best suited to investors and homeowners who only
intend to keep the home for a short time. It is not a good choice for anyone who may
be using it to buy more home than he or she can afford. Unfortunately, that describes
a lot of buyers who are taking out this type of loan. Anyone who is considering a

16
home purchase should be very careful if this type of loan is offered, as it could leave
you both bankrupt and homeless.

17
What is an Option ARM?

The Option ARM is a new version of the adjustable-rate mortgage (ARM) that allows
borrowers to choose how much to pay each month. Option ARMs are also known as
"pick-a-payment" or "cash-flow" ARMs.

Options ARMs usually give you four payments options. From smallest payment to
largest payment, they are:

1. Minimum payment (does not cover full interest for the period)
2. Interest-only payment (similar to interest-only ARMs)
3. Regular fully-amortized payment (the amount calculated using a 30-year
amortization table)
4. Accelerated payment (the amount calculated using a 15-year amortization
table)

You can pay the amount that you can afford each month. Option ARMs are helpful for
people with fluctuating incomes, such as commission-based sales persons or those
who are self-employed. Option ARMs may also be appropriate for sophisticated
investors who invest the monthly savings elsewhere or who sell the property quickly
before the loan is “recast” (more on recasting below).

A growing segment of Option ARM borrowers are those living in areas where home
prices are expensive, according to economy.com. (Source: “New Lessons For Your
Mortgage ,” July 22, 2005, CBS)

For most of us, mortgage payments are the biggest portion of our monthly budget. A
little payment flexibility is attractive. As long as you limit your use of the minimum or
interest-only payments to bona fide emergencies, Option ARMs could work to your
advantage. If you fall into the rut of paying interest-only or the minimum payments,
however, Option ARMs are very risky.

Risks

If you make regular fully-amortized payments each month, you will be on track. If
you make accelerated payments, you will even in better shape -- you will pay off
your mortgage faster than the usual 30 years.

However, if you make the minimum or interest-only payments, you will face much
larger payments in the future that may break your budget. It is an easy trap to fall
into: 70% of option ARM borrowers made minimum payments in the first quarter of
2005. (Source: “New Lessons For Your Mortgage,” July 22, 2005, CBS) (Use our
online calculator, “Minimum Payments on an Option ARM” to compute the monthly
payment.)

No Amortization or Negative Amortization

18
If you make interest-only payments, your loan will not be amortized or reduced
because you pay only the interest portion of your monthly payment, without making
a dent in the principal. (A regular monthly payment would consist of a principal and
interest component.)

If you make only the minimum payment, the situation gets even worse. The
minimum payment does not even cover the interest accumulated for the month. The
shortfall is added back into your loan balance. That results in what is known as
“negative amortization” – i.e., the loan balance grows, rather than being amortized.
You will owe more than you originally did, even though you made payments every
month.

Fluctuating Mortgage Payments

Like regular ARMs, the rates of Option ARMs change periodically with the
corresponding linked index, and are typically subject to rate caps.

With the exception of the minimum payment option, your monthly payment will
typically be adjusted every month to reflect changes in the underlying index rate.
The only limitation on these changes is the periodic rate cap.

The minimum payment amount is usually adjusted annually. Increases in the

minimum payment will typically be capped so as to not be greater than 7.5% of the
prior year’s minimum payment.

Recast

In addition to monthly or annual payment adjustments, an Option ARM will be

“recast” or recalculated (a) every five years, or (b) when your loan balance grows to
a certain value (typically 110% to 125% of the original loan amount), whichever
occurs first. If you keep making the minimum payment or the interest rate is rising
rapidly, the recast could be triggered in less than five years.

When the recast is performed, the rate cap or payment cap is ignored. Your monthly
payment could rise to whatever it takes for the loan to be repaid in the remaining
period (e.g., if the loan is recast at the end of the 5th year, the remaining period is 25
years). Your monthly payment could rise sharply, due to the shorter payoff period
coupled with the increased loan balance. Thus, the payment shock -- i.e, a sudden
and unprepared jump in payment -- could be even greater on Option ARMs than on
regular ARMs, as you will not be protected by the rate cap.

Payment F

For instance, Table 1 compares the monthly payments on a $200,000 loan under
three types of mortgages:

• 30-year fixed-rate mortgage (FRM), with a 6% interest rate

19
 • 30-year hybrid ARM. The rate is fixed (5.625%) for the fist 5 years and
adjusted annually thereafter.
• Option ARM. The minimum payment rate of 1%. 115% negative amortization
ceiling.

Table 1: Comparison of FRM, Hybrid ARM, and Option ARM

30-Year FRM 5/1 ARM Option ARM
Initial Monthly Payment $1,199 $1,151 $643
Loan Balance at the end of 5
$186,106 $185,225 $230,000
years
Monthly Payment at the
beginning of the 5th year:
(1) If the interest rate rises
$1,199 $1,265 $1,571
by 1%
(2) If the interest rate
$1,199 $1,151 $1,430
remains the same
(3) If the interest rate
$1,199 $1,043 $1,295
decreases by 1%
Source: "Housing and Mortgage Markets: An Analysis," August 23, 2005,
Mortgage Bankers Association

This example assumes that the negative amortization ceiling is reached at the end of
5 years ($200,000 × 115% = $230,000). The minimum payment on the Option ARM
will jump significantly higher after 5 years, even if the interest rate remains the
same.

Option ARMs are highly risky because not many borrowers can bear this kind of
payment shock. The high monthly payment may force you to sell your home. If your
home does not appreciate as fast as expected or depreciates, the proceeds from the
sales may not cover the mortgage, because your loan balance may have increased
due to the negative amortization. You may not be even able to refinance your loan
with better terms because you may owe more than the value of your home.

CAUTION: Lenders often advertise Option ARMs in misleading ways, such as 1%

Option ARM, as if the loan interest rate is 1%. This 1% is not the interest rate
charged on the loan, but usually is the rate that is used to calculate the minimum
payment.

20
 "Option Arm" Loans—The Not-So-Good You Need To Know

Seems like we all want the latest and hottest "thing" these days, and even some
mortgage loans are no exception. The lending industry seems intent on seeing
everyone in America become a homeowner by introducing new adjustable rate loan
products that give a false impression that home ownership is both cheap and
affordable despite soaring home prices.

Contrary to the good advice of many financial experts, more and more would-be and
current homeowners are being lured into loans that can backfire and possibly even
render you homeless in a few years if your income cannot keep pace with increasing
monthly mortgage payments and a rising interest rate environment.

One of these adjustable loan products introduced to the average consumer is the
"Option ARM" home loan, also known by several names like "Pick-A-Pay Loan", the
"Flex Pay Loan", "Flex Option ARM", and "Pay Option ARM", among others. It's other
alias doesn't sound quite as attractive: a negative amortization loan ("neg-am" loan
for short).

Lenders use the low starting rate or sometimes the low introductory monthly
payment in their advertisements for these loans as a hook to get your interest. "Just
imagine," they say, "having a 30—year home loan with an interest rate as low as
1.25%", or "a $500,000 home loan for just $1666 a month!". Some even go so far as
to advertise these loans with no closing costs! Wow! Sounds like a great deal, so
what's the problem?

While these advertisements are not inherently false, they're only short-term truths.
As with any longer-term financial commitment like a mortgage, the "devil is in the
details" as they say.

For those of you with short attention spans (or detest long articles), I've summarized
the 5 most important reasons most homeowners should steer clear of the Option
ARM loan:

1. Your mortgage payment will increase over time. If you like the security of
knowing what your payment will be from month to month or year to year, this is NOT
the loan for you because it is based on an adjustable rate index, and there are forces
at work in this type of loan beyond your control that can drive your payments up to
an unaffordable level in a relatively short period of time or in certain market
conditions. A $350,000 Option Arm Loan at a 1.25% start rate based on the current
MTA Index (3.88%) with a 2.75% margin has an initial monthly minimum annual
payment of $1166.38. Even with the standard 7.5% annual payment cap in place, in
year 5 the same loan will cost you $1557.66 per month. That's a difference of nearly
$400 in increased monthly minimum payments in just 5 years. That's assuming the
loan doesn't negatively amortize to the maximum allowed over that period of time. If
it were to achieve it's "neg cap", your payment could increase far beyond $400 per
month.

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2. You could end up owing more on your home loan than you started with.
This is the effect of negative amortization. Negative amortization occurs when the
mortgage payment is less than the interest due and causes your loan balance to
increase rather than decrease, a byproduct of the Option ARM loan. If you want the
benefit of a lower interest rate than those of fixed-rate loans, get a conventional
adjustable rate mortgage loan with the option of making interest-only payments and
avoid any loan that contains a provision for negative amortization.

3. There's always a prepayment penalty attached to Option ARM loans. An

Option ARM loan is the worst possible loan to be locked into for a long time, yet these
loans always come with a stiff prepayment penalty. Lenders don't want borrowers
jumping in and out of these loans for the low start rates, and brokers make HUGE
rebate earnings (up to 3.5 points) from lenders for selling extended penalty terms.
Borrowers with decent credit can get any other loan product available without being
forced to accept a prepayment penalty.

4. Obtaining a 2nd mortgage can be extremely difficult when you have an

Option ARM 1st loan. This is one of the least known facts about having an Option
ARM loan. Second mortgages are far and away easier to obtain when your first
mortgage is anything other than an Option ARM loan. I won't go into all the details
here, but suffice it to say that the potential for an Option ARM loan to negatively
amortize places a second lender in a more precarious position than when loaning
behind any other loan type, and many won't do it or otherwise restrict the amount of
the second loan to take into consideration the full negative potential of the first
mortgage. And in cases where the Option ARM first loan exceeds $1 million dollars,
there are only a select handful of lenders that will assume that risk. Call me if you
need a 2nd mortgage behing a neg-am 1st loan. We have lenders for these
situations.

5. Finally, an Option ARM loan is only for the most financially disciplined
homeowner who can both afford to make the different payment options (and
the discipline to do so) and have a decent equity cushion in the property. The
Option ARM loan was never intended as a means for someone living on average
hourly wages or salaried income to afford a home, especially over the long haul.
Certainly as a short-term loan option it's not too bad.

I believe that most people when given the choice between making a loan payment of
more or less will invariably opt to pay less as often as possible, making the Option
ARM loan the worst loan for most people due to it's inherent risks. Let's face it, if you
can only afford the interest-only payment on this type of loan, you'll never need the
options of paying 15 or 30-year amortizing payments, so stick with a loan that offers
an interest-only payment option without the potential pitfall of negative amortization.

After reading the above you might think I'm biased against the Option ARM loan, and
you'd be right to a certain degree. Of all the loan options available in today's
marketplace, there is no other loan that is as complicated, risky, or downright
unnecessary to all but a handful of very disciplined homeowners who know how to

22
take advantage of this type of financing, such as self-employed, high-commission
earning homeowners who need the added flexibilty of a loan like the Option ARM.

Everyone else should forget about low introductory rates and stick with a good old
fashioned fixed rate loan.

Hazards of option ARMs

Interest-only mortgages have gotten a lot of ink lately, but there's another type of
potentially risky home loan that deserves even more scrutiny, according to some in
the real estate industry.

Known as an option ARM, it's an adjustable-rate mortgage that typically lets

borrowers choose one of four different payments each month. From smallest to
largest, they are: a minimum monthly payment, an interest-only payment, full
principal and interest amortized over 30 years, or full principal and interest amortized
over 15 years.

Those who choose the interest-only payment pay no principal that month, but they
pay the full amount of interest due, so their loan balance stays the same.

Those who choose the minimum payment pay no principal, and less interest than
what accrues on the loan. The unpaid interest is added to the loan balance, resulting
in what's known as negative amortization.

If borrowers continue to make the minimum payment, their loan balance will grow,
and if interest rates rise, it will grow even faster, up to a point. When the balance
reaches a certain point -- usually 110, 115 or 125 percent of the original balance,
depending on the loan -- the loan is "recast" and the minimum payment goes up.

Option ARMs are the reincarnation of negative amortization loans, which were
popular in the 1980s (especially in Texas and the Southwest) but fell out of favor in
the early 1990s, when interest rates shot up and home prices fell in certain areas,
leaving some borrowers owing more than their homes were worth, according to Keith
Gumbinger, a vice president with HSH Associates.

Option ARMs are newer than interest-only loans, but growing fast. In 2004, they
accounted for about 5 percent of all home loans that were securitized, or packaged
and sold to investors, according to Fitch Ratings.

Interest-only loans accounted for about 31 percent of all new mortgages last year,
but David Lareah, chief economist with the National Association of Realtors, says he
is more worried about option ARMs than interest-only loans.

23
"They are a lot more dangerous," he says, because "the borrower is giving away part
of his equity," sometimes unknowingly.

Although the loan documents disclose the risks, the marketing materials are not
always forthcoming. "The brochure starts out by saying, 'Here is your monthly
payment.' It looks so low, you make an appointment, go to the lender," Lareah says.
"They have to tell you eventually it's negative am, but by the time they tell you, you
are emotionally into it."

The loans are often pitched as a good option for people with variable incomes -- such
as the self-employed and those who get year-end bonuses -- because they can adjust
their monthly payments.

But they are also being used by people to buy more house than they could otherwise
afford, causing some concern that they could default if interest rates should rise.

"Clearly, some people use it as an affordability product," says Mark Douglass, a

senior director with Fitch Ratings, which evaluates mortgage- backed securities.

Fitch has found that on average, roughly half of the people with option ARMs tend to
"negatively amortize" during the first five years, meaning they pay less than the
interest-only amount, thereby adding to their mortgage balance. About 10 percent
pay the interest-only amount and the rest make a fully amortizing payment.

After the first five years, very few amortize negatively, Douglass says. He says option
ARMs can be risky but in certain cases, less risky than interest-only loans. A new
Fitch study measures risk based on the "payment shock" borrowers would experience
if interest rates rise by certain amounts.

With an option ARM, the potential payment shock depends on three things: the
interest-rate index, the teaser rate and the negative amortization balance cap (or
how much the balance can exceed the original balance).

Most option ARMs are tied to either the moving Treasury index, the 11th District Cost
of Funds Index (COFI) or the London Interbank Offered Rate (LIBOR).

The fully indexed rate is some margin, typically two to three percentage points,
above the index.

A lower rate, known as the initial or teaser rate, is used to calculate the first month's
payment, and the minimum monthly payments for the first year. Teaser rates are
usually 1 to 2 percent.

The teaser rate sets the minimum payment, not the total payment. The total
payment (starting in month two) is based on the fully indexed rate.

24
If borrowers make the minimum payment, the difference between it and what they
would have paid at the fully indexed rate is added to the balance.

Gumbinger of HSH gives this example:

Suppose you borrow $400,000. The fully indexed rate is LIBOR plus 2.5 percent. The
teaser rate is 1.5 percent. The balance cap is 115 percent of the original loan. The
minimum payment for the first year would be about $1,380 per month ($400,000 at
1.5 percent).

The interest-only payment -- based on a fully indexed rate of 5.63 percent -- would
be $1,875 in the second month. (This amount will go up and down each month, with
LIBOR.)

If the borrower makes the minimum payment, the difference between it and the
interest-only payment -- about $495 the second month -- is added to the balance.

If the borrower wanted to make a full principal and interest payment, it would be
$2,303 (based on a 30-year payoff) or $3,295 (using a 15-year payoff) in the second
month.

In the second year, the minimum payment can go up by a maximum amount,

typically 7.5 percent. But the loan continues to accrue interest at the fully indexed
rate. If the loan builds up so much negative amortization that the balance reaches
115 percent of the original amount ($460,000 in our example), the lender will start
demanding higher payments to eliminate the negative amortization.

These are the bare basics of option ARMs. There are more features that make them
nearly impossible to compare lender to lender. (For details, go to mortgage-
x.com/library/option_arm.asp.)

Getting back to payment shock, Douglass says that the lower the teaser rate, the
higher the potential increase in monthly payments if interest rates should rise.

Option ARMs that are tied to the moving Treasury index or the cost of funds index,
which are lagging indicators, will be less volatile than ones tied to LIBOR, which is a
faster-moving index.

The former types "are less likely to breach their negative amortization balance cap"
quickly and require higher payments, says Douglass.

Loans with lower balance caps are less risky than ones with higher balance caps
because they allow the borrower to dig a smaller hole.

Douglass says option ARMs certainly can be more risky than interest-only loans, "but
they are not in all cases."

25
Most interest-only loans are also adjustable rate, but the rate can be fixed for an
initial period, such as five years. After five years, the interest rate is reset at
prevailing rates, and principal payments also begin, amortized over the remaining
period of the loan. If interest rates have risen over five years, borrowers can face a
double whammy. In some cases, this payment shock could exceed the shock from
one of the more conservative option ARMs, Douglass says.

26
 Option Arm Mortgages' Advantages.
The hottest mortgage program on the market these days is the option arm
mortgage. Also known as the 12 MAT or pick-a-payment mortgage, there are at
least 4 good reasons why smart and savvy borrowers are flocking to these
mortgages... they give the borrower 4 different choices for payment amounts each
month.

The first payment choice can be based on a starting rate as low as .95%. The second
payment choice can be based on an interest only option. The third payment choice
can be based on a principal and interest payment amortized over 30-years. And, for
those who want to build equity faster, or just have the money available, the fourth
choice is a principal and interest payment based on amortization of your mortgage
over a 15-year term. Essentially, the option arm gives borrowers flexible options each
month to manage their cash flow and monthly budget with more control.

The pay option ARM program can be an excellent mortgage program for someone
who needs to pay down credit card debt, but cannot qualify for a Cash-Out
Refinance.

Option arms are portfolio products often held by the lender. They are not purchased
by Fannie Mae or Freddie Mac.

Option Arms (1% Payment loan)

Option arms or the pick your payment loan can adapt to fit your lifestyle. They offer
flexible payment options and qualification standards. Investors like them for there
low payments and cash flow potential.

Traditional home loan payments are the same each month for the term of the loan.
With an Option ARM, you can choose from one of four payment choices each month
-- which gives you the flexibility to change your mortgage payment as your needs
change. You are only required to make the minimum payment on the loan each
month.
Payment Options
1. Minimum Payment
2. Interest Only Payment
3. Fully Amortized 30 year payment
4. 15 Year Payment

Main Benefits of an Option Arm

To minimize your house payment to pay off other debt.

To control how much tax-deductible interest you pay monthly.
To maximize your buying power.
If your income tends to fluctuate.

27
How an Option Arm Works

The minimum payment can only increase or decrease by 7.5% per year. There would
be an adjustment to your payment is rates have moved up or down. After 5-years an
option arm will recasts which ensure your loan will be repaid within the given term or
30 years. This means your new payment would be calculated to pay the loan off in 25
years.
Since the minimum payment is so low you may not be paying off all of the interest
each month. This is called deferred interest and will be added to your principal
balance. Deferred interest can be tax deductible when you refinance or sell your
home.
A lifetime interest rate cap limits how high your interest rate can reach.

One of the most effective Pay Option ARMs available are those that have a true bi-
weekly feature. This feature, when holding onto the loan for more than 3 years can
dramatically reduce the deferred interest and actually help pay the mortgage down,
often faster than a conventional 30 year fixed mortgage, over a 30 year cycle. Thus
the borrower gets the best of both worlds, the lowest payments possible with very
little interest expenses over the life of the loan.

The pay option ARM program frees up a tremendous amount of cash flow.

Pay option ARMs are a great way to manage your cash flow. However, keep in mind
that, when you make minimum payments, you are not paying all the interest due for
that month. This unpaid interest is added to your mortgage balance.

Pay option ARM mortgages can be used to refinance your current mortgage or to
finance a home purchase. Pay option ARMs are also known as option ARM, 12 month
MTA, cash flow ARM and other titles.

Option arms or the pick your payment loan can adapt to fit your lifestyle. They offer
flexible payment options and qualification standards. Investors like them for there
low payments and cash flow potential.

Pay Option Arms are good for investment properties, where a higher cashflow is
desired in the first few years of ownership.

This loan very popular with borrowers who are self-employed, work on commssion or
have variable income sources. They enjoy the payment flexibility that the PO ARM
program offers. In a month when income is low and money is tight there is the
minimum payment to fall back on as conversely in a month where things are good
they can make a higher payment.

Pay option ARMS usually have hard pre pay penalties that range from 1-3 years. Ask
your mortgage broker about different pre pay options and how they will fit into your
future financial plans.

28
A few words of caution: If you choose to pay the minimum payment option, your
payment will not cover the cost of the interest payment and your loan balance will
increase. This is called Negative Amortization. If you find yourself with a negative
amortization option arm, you'll be adding to your mortgage debt every month. The
difference between the minimum payment and the interest-only payment is not
discarded - it goes back into your principal loan amount - in effect growing the
amount you owe every month. It's best to only use the minimum payment option in
the case of a tight money month.

Pay Option Arms are fantastic opportunities for Apprentice workers to purchase a
home they will be able to afford 3-4 years from now when there apprenticeship is
done, right now.

Most homeowners consider Pay Option ARM for one or more of the following
advantages this mortgage program offers:

1. To be able to buy more home with the same income

2. To be able to allocate a bigger portion of income towards other debts
3. To have control over tax deductability of mortgage interests from year to year
4. To off set seasonal incomes
5. To take advantage now of anticipated increase in income

A Pay Option ARM is one of the fastest growing mortgage products available. This
program allows the borrower the most flexibility with their mortgage payment each
month by allowing, usually, 3-4 different payment options on each mortgage billing
statement each month. Option 1 is generally the lowest payment option which can
incur negative amortization. Option 2 is usually an interest only mortgage payment.
Option 3 may be a 15 year mortgage payment. Finally Option 4 may be a 30 year
mortgage payment. The Pay Option ARM is great for self-employed and
commissioned borrowers who may not receive a steady income. This gives these
borrowers the opportunity to pay incredibly low monthly mortgage payments during
slow months and pay their normal payments during the other months.

29
The Options ARMs can be both interest-only as well as repayment mortgages. The
various payment options are listed below.

• Minimum Payment
This repayment option allows you to make fixed monthly payments at a fixed
rate of interest for a year. At the end of the year, the payment changes
annually, but the change is limited to a certain amount due to a payment cap
being applied on the loan.

• Interest-Only Payment
The interest-only payment allows you to avoid deferred interest when the
minimum payment is not sufficient to pay off the interest. This option is not
available when the interest-only payment is less than the minimum payments.
The interest-only option allows you to pay only the interest for an initial period
after which he pays both interest as well as principal. The interest-only
payment changes every month with variation in the ARM index that determines
your indexed rate.

Therefore, the Option ARM is both an interest-only as well as repayment mortgage.

Apart from the payment options that Caron mentions, there are two more ways of
repaying the mortgage loan.

• Fully amortizing 30-Year Payment:

With this option, you pay both the principal and interest as per schedule. Your
payment is calculated each month based on the previous month's fully indexed
rate, loan balance and remaining loan period.

• Fully amortizing 15 year payment:

This option allows you to make comparatively higher monthly payments than
the 30 year payment option. It helps you to repay the loan much faster than
the 30 year payment option and thereby save more than half the interest
payments on a 30 year loan.

An "option ARM" is a loan where the borrower has the option of making either a
specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed
rate in a given month. [1] The minimum payment is less than an interest-only
payment and therefore results in negative amortization, while the full payment is the
fully-amortized share of interest and principal.

Option ARMs are popular because they are usually offered with a very low initial
interest rate (a so-called "teaser rate") and a low minimum payment, which permits
borrowers to qualify for a much larger loan than would otherwise be possible.

Option ARMs are best suited to people in fields with sporadic income, such as some
self-employed people or those in a highly seasonal business. For example, someone
who makes the majority of their income around the winter holiday season, but who
earns minimal income during the following few months may wish to pay the full

30
payment during their busy season, but drop back to the interest-only payment or the
minimum during a period of reduced earnings. With a fixed-payment loan, if they
were unable to meet the payment during their lean season they would risk late fees
or foreclosure.

The main risk of an Option ARM is "payment shock", when the negative amortization
reaches a stated maximum, at which point the minimum payment will be raised to a
level that amortizes the loan balance. Another risk, as with any loan with potential
negative amortization, is that the increased loan balance will reduce or eliminate the
borrower's equity in the financed property, or if the value of the property declines,
make it impossible to sell the property for an amount that will repay the loan.

31
 Payment Shock
A situation that occurs when an adjustable-rate mortgage (ARM) monthly mortgage
payments rise very sharply at an adjustment. The borrower may not be able to afford
the payments the loan will require.

For many first time home buyers or current homeowners looking to move up, can be
in for a shock. Even if they are aware of the higher payment from their current rent
or mortgage and are ok with it and still have qualifying debt ratios, lenders still look
at payment shock as a factor in determining whether or not your loan is approved.

If you have been making payments on a $100k mortgage and are going to jump into
a million dollar home some lenders will look at this in an unfavorable manner even if
your income supports it.

Every lender and situation is different so you must inquire/apply for a mortgage and
we will be able to assist you in purchasing that particular property.

What is an ARM?

With a fixed-rate mortgage, the interest rate stays the same during the life of the
loan. But with an ARM, the interest rate changes periodically, usually in relation to an
index, and payments may go up or down accordingly.

Lenders generally charge lower initial interest rates for ARMs than for fixed-rate
mortgages. This makes the ARM easier on your pocketbook at first than a fixed-rate
mortgage for the same amount. It also means that you might qualify for a larger loan
because lenders sometimes make the decision about whether to extend a loan on the
basis of your current income and the first year’s payments. Moreover, your ARM could
be less expensive over a long period than a fixed-rate mortgage--for example, if
interest rates remain steady or move lower.

Against these advantages, you have to weigh the risk that an increase in interest
rates would lead to higher monthly payments in the future. It’s a trade-off--you get a
lower rate with an ARM in exchange for assuming more risk.

Here are some questions you need to consider:

Is my income likely to rise enough to cover higher mortgage payments if
interest rates go up?
Will I be taking on other sizable debts, such as a loan for a car or school
tuition, in the near future?
How long do I plan to own this home? (If you plan to sell soon, rising
interest rates may not pose the problem they do if you plan to own the
house for a long time.)
Can my payments increase even if interest rates generally do not increase?

32
How ARMs Work: the Basic Features

The adjustment period

With most ARMs, the interest rate and monthly payment change every year, every
three years, or every five years. However, some ARMs have more frequent rate and
payment changes. The period between one rate change and the next is called the
“adjustment period.” A loan with an adjustment period of one year is called a one-
year ARM, and the interest rate can change once every year.

The index

Most lenders tie ARM interest-rate changes to changes in an “index rate.” These in-
dexes usually go up and down with the general movement of interest rates. If the
index rate moves up, so does your mortgage rate in most circumstances, and you will
probably have to make higher monthly payments. On the other hand, if the index
rate goes down, your monthly payment may go down.

Lenders base ARM rates on a variety of indexes. Among the most common indexes
are the rates on one-, three-, or five-year Treasury securities. Another common index
is the national or regional average cost of funds to savings and loan associations. A
few lenders use their own cost of funds as an index, which gives them more control
than using other indexes. You should ask what index will be used and how often it
changes. Also ask how it has fluctuated in the past and where it is published.

The margin

To determine the interest rate on an ARM, lenders add to the index rate a few
percentage points, called the “margin.” The amount of the margin may differ from
one lender to another, but it is usually constant over the life of the loan.

Index rate + margin = ARM interest rate

Let’s say, for example, that you are comparing ARMs offered by two different lenders.
Both ARMs are for 30 years and have a loan amount of $65,000. (All the examples
used in this booklet are based on this amount for a 30-year term. Note that the
payment amounts shown here do not include taxes, insurance, or similar items.)

Both lenders use the rate on one-year Treasury securities as the index. But the first
lender uses a 2% margin, and the second lender uses a 3% margin. Here is how that
difference in the margin would affect your initial monthly payment.

In comparing ARMs, look at both the index and margin for each program. Some
indexes have higher values, but they are usually used with lower margins. Be sure to
discuss the margin with your lender.

33
 Home sale price $ 85.000

Less down payment - $ 20.000

Mortgage amount = $ 65.000

Mortgage term 30 years

FIRST LENDER

One-year index = 8%

Margin = 2%

ARM interest rate = 10%

Monthly payment @ 10% = $ 570.42

SECOND LENDER

One-year index = 8%

Margin = 3%

ARM interest rate = 11%

Monthly payment @ 11% $ 619.01

Back to top

Consumer Cautions

Discounts

Some lenders offer initial ARM rates that are lower than their “standard” ARM rates
(that is, lower than the sum of the index and the margin). Such rates, called
discounted rates, are often combined with large initial loan fees (“points”) and with
much higher rates after the discount expires.

Very large discounts are often arranged by the seller. The seller pays an amount to
the lender so that the lender can give you a lower rate and lower payments early in
the mortgage term. This arrangement is referred to as a “seller buydown.” The seller
may increase the sales price of the home to cover the cost of the buydown.

A lender may use a low initial rate to decide whether to approve your loan, based on
your ability to afford it. You should be careful to consider whether you will be able to
afford payments in later years when the discount expires and the rate is adjusted.
Here is how a discount might work. Let’s assume that the lender’s “standard” one-

34
year ARM rate (index rate plus margin) is currently 10%. But your lender is offering
an 8% rate for the first year. With the 8% rate, your first-year monthly pay-ment
would be $476.95.

But don’t forget that with a discounted ARM, your initial payment will probably
remain at $476.95 for only 12 months--and that any savings during the discount
period may be made up during the life of the mortgage or may be included in the
price of the house. In fact, if you buy a home using this kind of loan, you run the risk
of . . .

Payment shock

Payment shock may occur if your mortgage payment rises very sharply at the first
adjustment. Let’s see what would happen in the second year if the rate on your
discounted 8% ARM were to rise to the 10% “standard” rate.

ARM Interest Rate Monthly

Payment

1st year (w/discount) @ 8% $ 476.95

2nd year @ 10% $ 568.82

As the example shows, even if the index rate were to stay the same, your monthly
payment would go up from $476.95 to $568.82 in the second year.

Suppose that the index rate increases 2% in one year and the ARM rate rises to
12%.

ARM Interest Rate Monthly

Payment

1st year (w/discount) @ 8% $ 476.95

2nd year @ 12% $ 665.43

That’s an increase of almost $200 in your monthly payment. You can see what might
happen if you choose an ARM because of a low initial rate. You can protect yourself
from large increases by looking for a mortgage with features, described next, that
may reduce this risk.

Back to top

How Can I Reduce My Risk?

35
Besides offering an overall rate ceiling, most ARMs also have “caps” that protect
borrowers from extreme increases in monthly payments. Others allow borrowers to
convert an ARM to a fixed-rate mortgage. While they may offer real benefits, these
ARMs may also cost more, or may add special features such as negative
amortization.

Interest-rate caps

An interest-rate cap places a limit on the amount your interest rate can
increase. Interest caps come in two versions:
Periodic caps, which limit the interest-rate increase from one adjustment
period to the next; and
Overall caps, which limit the interest-rate increase over the life of the loan.

By law, virtually all ARMs must have an overall cap. Many have a periodic cap.

Let’s suppose you have an ARM with a periodic interest-rate cap of 2%. At the first
adjustment, the index rate goes up 3%. The example shows what happens.

ARM Interest Rate Monthly Payment

1st year @ 10% $ 570.42

2nd year @ 13% (without cap) $ 717.12

2nd year @ 12% (with cap) $ 667.30

Difference in 2nd year between payment with cap and

payment without = $ 49.82

A drop in interest rates does not always lead to a drop in monthly payments. In fact,
with some ARMs that have interest-rate caps, your payment amount may increase
even though the index rate has stayed the same or declined. This may happen when
an interest-rate cap has been holding your interest rate down below the sum of the
index plus margin. If a rate cap holds down your interest rate, increases to the index
that were not imposed because of the cap may carry over to future rate adjustments.

With some ARMs, payments may increase even if

the index rate stays the same or declines.

The following example shows how carryovers work. The index increased 3% during
the first year. Because this ARM limits rate increases to 2% at any one time, the rate
is adjusted by only 2%, to 12% for the second year. However, the remaining 1%
increase in the index carries over to the next time the lender can adjust rates. So
when the lender adjusts the interest rate for the third year, the rate increases 1%, to
13%, even though there is no change in the index during the second year.

36
 ARM Interest Rate Monthly Payment

1st year @ 10% $ 570.42

If index rises 3% . . .
2nd year @ 12% (with 2% rate $ 667.30
cap)

If index stays the same for the 3rd $ 716.56

year @ 13%

Even though the index stays the same in 3rd year,

payment goes up $49.26

In general, the rate on your loan can go up at any scheduled adjustment date when
the lender’s standard ARM rate (the index plus the margin) is higher than the rate
you are paying before that adjustment.

The next example shows how a 5% overall rate cap would affect your loan.

ARM Interest Rate Monthly

payment

1st year @ 10% $ 570.42

10th year @ 15% (with cap) $ 813.00

Let’s say that the index rate increases 1% in each of the next nine years. With a 5%
overall cap, your payment would never exceed $813.00—compared to the $1,008.64
that it would have reached in the tenth year based on a 19% interest rate.

Payment caps

Some ARMs include payment caps, which limit your monthly payment increase at the
time of each adjustment, usually to a percentage of the previous payment. In other
words, with a 7½% payment cap, a payment of $100 could increase to no more than
$107.50 in the first adjustment period, and to no more than $115.56 in the second.

Let’s assume that your rate changes in the first year by 2 percentage points but your
payments can increase by no more than 7½% in any one year.

Here’s what your payments would look like:

ARM Interest Rate Monthly

payment

1st year @ 10% $ 570.42

37
 2nd year @ 12%
(without payment cap) $ 667.30

2nd year @ 12%

(with 7½% payment cap) $ 613.20

Difference in monthly
payment = $ 54.10

Many ARMs with payment caps do not have periodic interest-rate caps.

Negative amortization

If your ARM includes a payment cap, be sure to find out about “negative amortiza-
tion.” Negative amortization means that the mortgage balance increases. It occurs
whenever your monthly mortgage payments are not large enough to pay all of the
interest due on your mortgage.

Because payment caps limit only the amount of payment increases, and not interest-
rate increases, payments sometimes do not cover all the interest due on your loan.
This means that the interest shortage in your payment is automatically added to your
debt, and interest may be charged on that amount. You might therefore owe the
lender more later in the loan term than you did at the start. However, an increase in
the value of your home may make up for the increase in what you owe.

The next illustration uses the figures from the preceding example to show how
negative amortization works during one year. Your first 12 payments of $570.42,
based on a 10% interest rate, paid the balance down to $64,638.72 at the end of the
first year.

The rate goes up to 12% in the second year. But because of the 7½% payment cap,
your payments are not high enough to cover all the interest. The interest shortage is
added to your debt (with interest on it), which produces negative amortization of
$420.90 during the second year.

Beginning loan amount = $65,000

Loan amount at end of 1st year = $ 64,638.72

Negative amortization during 2nd year = $ 420.90

Loan amount at end of 2nd year = $ 65,059.62

($ 64,638.72 + $ 420.90)

(If you sold your house at this point, you would owe
almost $60 more than you originally borrowed)

38
To sum up, the payment cap limits increases in your monthly payment by deferring
some of the increase in interest. Eventually, you will have to repay the higher
remaining loan balance at the ARM rate then in effect. When this happens, there may
be a substantial increase in your monthly payment.

Some mortgages include a cap on negative amortization. The cap typically limits the
total amount you can owe to 125% of the original loan amount. When that point is
reached, monthly payments may be set to fully repay the loan over the remaining
term, and your payment cap may not apply. You may limit negative amortization by
voluntarily increasing your monthly payment.

Be sure to discuss negative amortization with the lender to understand how it will
apply to your loan.

Prepayment and conversion

If you get an ARM and your financial circumstances change, you may decide that you
don’t want to risk any further changes in the interest rate and payment amount.
When you are considering an ARM, ask for information about prepayment and
conversion.

Prepayment. Some agreements may require you to pay special fees or penalties if
you pay off the ARM early. Many ARMs allow you to pay the loan in full or in part
without penalty whenever the rate is adjusted. Prepayment details are sometimes
negotiable. If so, you may want to negotiate for no penalty, or for as low a penalty as
possible.

Conversion. Your agreement with the lender may include a clause that lets you con-
vert the ARM to a fixed-rate mortgage at designated times. When you convert, the
new rate is generally set at the current market rate for fixed-rate mortgages.

The interest rate or up-front fees may be somewhat higher for a convertible ARM.
Also, a convertible ARM may require a special fee at the time of conversion.

Glossary

Adjustable-rate mortgage (ARM)

A mortgage for which the interest rate is not fixed, but changes during the life
of the loan in line with movements in an index rate. You may also see ARMs
referred to as AMLs (adjustable-mortgage loans) or VRMs (variable-rate
mortgages).

Annual percentage rate (APR)

39
A measure of the cost of credit, expressed as a yearly rate. It includes interest
as well as other charges. Because all lenders follow the same rules when
calculating the APR, it provides consumers with a good basis for comparing the
cost of loans, including mortgages.
Buydown

With a buydown, the seller pays an amount to the lender so that the lender can
give you a lower rate and lower payments, usually for an early period in an
ARM. The seller may increase the sales price to cover the cost of the buydown.
Buydowns can occur in all types of mortgages, not just ARMs.

Cap

A limit on how much the interest rate or the monthly payment may change,
either at each adjustment or during the life of the mortgage. Payment caps
don’t limit the amount of interest the lender is earning, so they may cause
negative amortization.

Conversion clause

A provision in some ARMs that allows you to change the ARM to a fixed-rate
loan at some point during the term. Conversion is usually allowed at the end of
the first adjustment period. At the time of the conversion, the new fixed rate is
generally set at one of the rates then prevailing for fixed-rate mortgages. The
conversion feature may be available at extra cost.

Discount

In an ARM with an initial rate discount, the lender gives up a number of

percentage points in interest to give you a lower rate and lower payments for
part of the mortgage term (usually for one year or less). After the discount
period, the ARM rate will probably go up depending on the index rate.

Index

The index is the measure of interest-rate changes that the lender uses to decide
how much the interest rate on an ARM will change over time. No one can be
sure when an index rate will go up or down. To help you get an idea of how to
compare different indexes, the following chart shows a few common indexes
over an eleven-year period (1994-2004). As you can see, some index rates tend
to be higher than others, and some more volatile. (But if a lender bases
interest-rate adjustments on the average value of an index over time, your
interest rate would not be as volatile.) You should ask your lender how the index
for any ARM you are considering has changed in recent years, and where the
index is reported.

40
 [d]

Margin

The number of percentage points the lender adds to the index rate to calculate
the ARM interest rate at each adjustment.

Negative Amortization

Amortization means that monthly payments are large enough to pay the interest
and reduce the principal on your mortgage. Negative amortization occurs when
the monthly payments do not cover all the interest cost. The interest cost that
isn’t covered is added to the unpaid principal balance. This means that even
after making many payments, you could owe more than you did at the
beginning of the loan. Negative amortization can occur when an ARM has a
payment cap that results in monthly payments not high enough to cover the
interest due.

Points

One point is equal to 1 percent of the principal amount of your mortgage. For
example, if the mortgage is for $65,000, one point equals $650. Lenders
frequently charge points in both fixed-rate and adjustable-rate mortgages in
order to increase the yield on the mortgage and to cover loan closing costs.
These points usually are collected at closing and may be paid by the borrower or
the home seller, or may be split between them.

41
Defining Characteristics

Negative amortization would only arise on loans with the following features:

• The minimum installment payment due does not cover the amount of interest
due on a loan. As a consequence, the balance rises. The purpose of such a
feature is to increase affordability, or add payment savings and payment
flexibility to a loan.

[edit]

Typical Circumstances

All NegAM home loans eventually require full repayment of principal and interest
according to the original term of the mortgage and note signed by the borrower. Most
loans only allow NegAM to happen for no more than 5 years, and have terms to
"Recast" (see below) the payment to a fully amortizing schedule if the borrower
allows the principal balance to rise to a pre-specified amount.

This loan is written often in high cost areas, because the monthly mortgage
payments will be lower than any other type of financing instrument.

Negative amortization loans can be high risk loans for inexperienced investors. These
loans tend to be safer in a falling rate market and riskier in a rising rate market.

[edit]

Adjustable Rate Feature

NegAM loans today are mostly straight Adjustable Rate Mortgages (ARMs), meaning
that they are fixed for a certain period and adjust every time that period has elapsed;
e.g., One month fixed, adjusting every month. The NegAm loan, like all Adjustable
Rate Mortgages, is tied to a specific financial index which is used to determine the
interest rate based on the current index and the margin (the markup the lender
charges). Most NegAm loans today are tied to the Monthly Treasury Average, in
keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans
in which there is a period of fixed payments for months or years, followed by an
increased change cycle, such as six months fixed, then monthly adjustable.

The Graduated Payment Mortgage is a "fixed rate" NegAm loan, but since the
payment increases over time, it has aspects of the ARM loan until amortizing
payments are required.

[edit]

42
NegAm - Mortgage Terminology

• Cap - percentage rate of change in the NegAm payment. Each year, the
minimum payment due rises. Most minimum payments today rise at 7.5%.
Considering that raising a rate 1% on a mortgage at 5% is a 20% increase,
the NegAm can grow quickly in a rising market. Typically after the 5th year, the
loan is recast to an adjustable loan due in 25 years.

• Life Cap - the maximum interest rate allowed after recast according to the
terms of the note. Generally most NegAm loans have a life cap of 9.95%.

• Payment Options - There are typically 4 payment options:

o Minimum Payment
o Interest Only Payment
o 30 Year Payment
o 15 Year Payment

• Period - how often the NegAm payment changes. Typically, the minimum
payment rises once every twelve months in these types of loans.

• Recast - premature stop of NegAm. Should your negative balance reach a

predetermined amount (typically 115% of the original balance, or 110% in
New York)) your loan will be "recast" with one of two payment options: the
fully amortized principal and interest payment, or if the maximum balance has
been reached before the fifth year, an interest only payment until the loan has
matured to the recast date. (typically 5 years)

• Stop - end of NegAm payment schedule.

43
Reasons to Use Pay Option ARMs to Finance Your Investment Property

Have you heard about all the bad press about Cash Flow ARMs, Pay Option ARM,
Smart Loans and all the other variations of loans with negative amortization? A lot of
it is warranted! This loan is a tool and just like any tool, there is a right way to use it

Have you heard about all the bad press about Cash Flow ARMs, Pay Option ARM,
Smart Loans and all the other variations of loans with negative amortization? A lot of
it is warranted! This loan is a tool and just like any tool, there is a right way to use it
and a wrong way!

Most people that get Pay Option ARMs do it simply to get a lower payment on the
house that they live in. They couldn’t afford it any other way. They finance the house
to the hilt and suddenly they get upside down when that balance starts to increase!

Pay option ARMs are a good choice when your home is seeing good appreciation (5%
or more) because this type of loan has the ability for negative amortization (the loan
balance can actually increase over time). In this case the amount of appreciation will
easily out pace any increase in the loan balance.

Pay option arms are good for property that you are financing under 90% of the value.
In fast appreciating markets you can get away with a higher amount but leaving 10%
equity in the house is bare minimum. Why? Well, If you sell the house through
traditional means, your selling cost could be anywhere from 9-15% of the sales price!
No one likes the idea of having to come out of pocket to get rid of a house! You want
to make money!

Real estate investors can find some of the biggest benefits in using pay option arms.
When you take a property that fits some of the criteria mentioned previously, using
pay options will afford you the following:

1. Payment Flexibility – Just like the name of the loan states, you have different
payment options. One, you have the payment based on the start rate of the loan
(which could be as low as 1%!). Two, you have the interest only payment. Three,
there is an option to make a payment based on a 30 year term. Lastly, the fourth pay
option is based on a 15 term. The last 2 pay options allow you to pay down on
principle if you choose.

2. Maximize cash flow – Cash flow is the name of the game when dealing with rental
property and pay option arms are one of the best ways to maximize it. Used
correctly, pay options arms can over DOUBLE the cash flow on your property!

3. Minimize affects of vacancy - Everyone who owns rental property has had
vacancies. If you haven’t yet, just wait you will! One month vacancy, depending on
the property, can just about destroy the profit for an entire year! Don’t believe me?

44
Go ahead and add up the holding cost for carrying the mortgage, utilites, cleaning,
and a little touch up paint and see what you get. If you had a way to reduce the
largest expense, the mortgage, by a third, wouldn’t that soften the blow? Again pay
option arms are the way to go!

4. No more worrying about unexpected repairs – In the same regard as the vacancy
example, you will be better able to shrug off the effects of an unexpected repair
because your cash flow has over doubled.

5. Give incentives to tenants for good behavior – You can be very creative here.
Credit for paying before the first of the month (for example payment by the 25th).
Discounts on longer term leases such as an 18-24 month lease, etc. The extra cash
flow from using a pay option arm can stabilize you turn over and give you tools to
help you with tenant retention, especially in competitive markets!

6. Leverage the property to payoff personal bills – If you cash flow from switching to
a pay option arm goes from $250 to $500 a month, you can use that extra money to
pay off your car, credit cards, student loans, whatever.

7. Save the extra income to buy more property! – Better yet, start saving that extra
cash flow to buy more property! You will use pay option arms, collect more cash flow
and use that to buy even more property! Then your business feeds off of itself
without you having to use your salary for your 9 to 5 to fund it!

Option ARM Loans

This loan type has become popular recently, and it is critical to understand how it
works before entering into one

Have you seen the ads everywhere for "1% Mortgage Loans" - offers that show how
you can chop you monthly payment in half?

These are Option ARM (adjustable rate mortgage) loans. They usually offer a low
start rate – 1%, 1.5%, 1.95%, 2%, etc.

This type of loan has become very popular recently, particularly in places with high
and escalating real estate values where the loan can allow people to buy or keep
expensive properties.

Basics

The Option ARM loan is a loan that has to be understood first because it can be good
or bad, depending on your circumstances and goals.

The Option ARM mortgage rate is usually an introductory rate (the APR or annual
percentage rate is usually much higher).

45
The initial interest rate may only be for the first month.

The appeal of this type of loan is that it typically allows you to make a choice each
month about how much you want to pay for your mortgage. That’s what makes it
different than a regular mortgage bill: you have an OPTION to choose which payment
you want to make.

These choices each month are usually a minimum payment (usually less than the
interest-only level), an interest-only level, a 15 year amortization level, or a 30 year
amortization.

Example

A 1% minimum option loan at $400,000 with a 30 year loan term can have four
different payment levels:

• the minimum payment of $1,287

• an interest-only payment of $1,649
• a 30 year payment of $2,134
• or a 15 year payment of $3,152.

When you get your bill, you can decide that month how much you pay.

The Catch

Here is the first catch: when you make the minimum payment, any amount short of
the interest-only payment is added onto the principal of the loan. If the interest-only
payment is $1,500 per month and you only pay $1,200 per month minimum
payment, then you are increasing the size of your loan by $300 ($1,500 less
$1,200). An increase in your loan size is known as “negative amortization”.

If you continue to make minimum payments over time, your loan balance will
continue to increase.

The level of your minimum payment can also be reset, typically on an annual basis.
The minimum payment is usually fixed for 12 month periods at a time. Once a year,
the minimum payment goes up slightly. For example, the minimum payment each
month for the first year may be $1,200, then the second year it may be $1,300, the
third year it may rise to $1,400, etc. Because of this escalating feature, some people
refinance again after around 3 years so they can go back to the lower minimum
payments.

46
Minimum payment levels usually last for the first 5 years of a loan, after which the
loan reverts back to a regular adjustable loan.

There can also be a reset of the loan if the loan size increases too much relative to
the value of the property.

For some people a minimum payment may be the option they choose once in a while,
such as around the holidays.

Interest Rate on Loan

What is the interest rate on this type of loan? Usually it adjusts on a monthly basis
and is the sum of an interest rate index plus the “margin” which is the bank’s profits.
The interest rate index can be based on different published indexes, such as the
LIBOR, COSI, or CODI index.

For example, your interest rate may be:

• 3.2% interest rate value for your index

• Plus 3% lender margin
• =Total 6.2% for that month

Some of these indexes change value faster than others. These loans also usually
come with a lifetime cap on the interest rate, so the upside interest rate risk is clearly
defined.

The Risk

If your loan continues to increase, and the value of your property drops, then you
can end up owing more on the property than the house is worth.

The Potential Uses

If you have lots of equity in your property and don't mind your loan size going up,
consider this loan. Often times, people have found that gains in property values are
higher than the increase in their loan size. For example, a customer may start the
year with a loan of $300,000 on a $400,000 property and may end the year with a
$310,000 loan on a $450,000 property. The borrower’s equity in the home has still
increased, despite the increase in loan amount. Of course, this is equity on paper.

The 1% loan often only goes up to the first 80% of the value of the property, after
which if an additional loan is necessary it is usually an equity line at a higher rate.
Borrowers will still use this loan because the combined expense is still lower than
other options.

Qualifications

47
This type of loan can be done with both full documentation and stated documentation
borrowers. This can depend on other factors, such as:

• Credit
• Level of equity in the property
• Borrower loan history

Because of the potential for negative amortization (where the loan size increases
rather than decreases), banks usually wanted to see some equity in the loan before
making it. This was usually at least 10% equity in the loan (for example, a $450,000
loan on a $500,000 property has 10% equity). This 10% equity gave the lender some
“cushion” if the loan value went up and the property declined in value.

There are now lenders that will do this with only 5% equity, and in some cases no
equity. These loans can be structured in two parts: the first 80% as a minimum
option payment loan, and the final 15% or 20% as a second loan with much higher
rates.

Rental Properties

For rental properties, a minimum payment may allow you to collect enough rent to
make a monthly profit or be closer to it. The size of the Option ARM loan relative to
the value of a rental property is usually lower than for a primary residence.

For some borrowers the minimum payment may be an attractive option because it
allows them to put the minimum cash into a property while riding up its value (this is
the concept of leverage).

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 Mortgage Type: Adjustable Rate Mortgages (ARMs)

What is Adjustable Rate Mortgage (ARM)?

A loan whose interest rate, and accordingly monthly payments, fluctuate

over the period of the loan. With this type of mortgage, periodic adjustments
based on changes in a defined index are made to the interest rate.

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 Terms Used when Dealing with ARMs

Index
The index of an ARM is the financial instrument that the loan is "tied" to, or
adjusted to. Each of these indices move up or down based on conditions of
the financial markets. Well known ARM Indexes include:

• Constant Maturity Treasury (CMT)

• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA)
• Certificate of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London Inter Bank Offering Rates (LIBOR)
• Certificates of Deposit (CD) Indexes
• Prime Rate
• Fannie Mae's Required Net Yield (RNY)

Margin
The margin is fixed percentage points added to the index to compute the
interest rate (interest rate = index + margin). The result will then be
rounded to the nearest one-eighth of a percent.
Note rate
The taking of the index plus [+] the margin equals [=] the note rate. As an
example if the current index value is 5.50% and your loan has a margin of
2.5%, your note rate is 8.00%. Margins on loans range from 1.75% to 3.5%
depending on the index and the amount financed in relation to the property
value.
Periodic Rate Cap
A cap that sets the limit on the amount that the interest rate can increase or
decrease during a single adjustment period, on an adjustable rate mortgage
( ARM )
Lifetime rate cap
A limit on how much the interest rate on an adjustable rate mortgage (ARM)
can go up or down over the life of a loan. The average lifetime rate cap is 5
to 6 percentage points over an ARM’s initial interest rate. So, for example, if
your initial interest rate is 6% and the lifetime rate cap is +5%, your rate
can’t go beyond 11% over the loan’s term. The maximum lifetime rate cap is
often called the ceiling. Thus, the minimum lifetime rate cap is called the
floor.
Payment Caps
A limit on how much monthly payments can fluctuate on an Adjustable Rate
Mortgage (ARM). Some ARMs have a payment cap, where payments are
typically limited to a 7.5% change, up or down, every 12 months. The
payment cap feature is usually offered with a low initial rate. The combined
benefit is very low minimum payments in the first year, followed by
moderate payment increases (7.5%) in subsequent years. One potential

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Option Arm Mortgages' Advantages.
The hottest mortgage program on the market these days is the option arm
mortgage. Also known as the 12 MAT or pick-a-payment mortgage, there are at
least 4 good reasons why smart and savvy borrowers are flocking to these
mortgages... they give the borrower 4 different choices for payment amounts each
month.

The first payment choice can be based on a starting rate as low as .95%. The second
payment choice can be based on an interest only option. The third payment choice
can be based on a principal and interest payment amortized over 30-years. And, for
those who want to build equity faster, or just have the money available, the fourth
choice is a principal and interest payment based on amortization of your mortgage
over a 15-year term. Essentially, the option arm gives borrowers flexible options each
month to manage their cash flow and monthly budget with more control.

Option ARMs have benefits and also risks

Consumers increasingly bear risks that lenders once carried, with the federal
government encouraging the trend. Exhibit A: the popularity of the adjustable-rate
mortgages called option ARMs. These mortgages bestow benefits if you use them
right, but they can put you in financial peril by hitting you with a giant payment
increase.

Get an option ARM only if you comprehend how it is structured and understand the
risk you are taking.

"These things are tools," says Bob Walters, chief economist for Quicken Loans. "Is a
chainsaw a good thing or a bad thing? If you're cutting down a stand of trees, it's a
good thing. If you accidentally chop off your finger, it's a bad thing."

The head of the nation's central bank virtually told mortgage lenders to load their
shelves with chainsaws a year and a half ago. Lenders heeded his call. Now Federal
Reserve Chairman Alan Greenspan worries about an epidemic of severed fingers.

Speaking before the Credit Union National Association, on Feb. 23, 2004, Greenspan
lamented that not enough people had taken out adjustable-rate mortgages, or ARMs,
in previous years.

ARMs have lower rates than fixed-rate loans. The reason: With an ARM, the borrower
risks higher payments if rates increase. With a fixed-rate mortgage, the lender risks
getting stuck with a low-yield investment if rates rise.

Greenspan was a fan

About two-thirds of homeowners get fixed-rate mortgages, paying a higher rate so
the deep-pocket lender takes the risk. In his speech in 2004, Greenspan complained
that a lot of those borrowers wasted money by spurning ARMs.

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"American consumers might benefit if lenders provided greater mortgage-product
alternatives to the traditional fixed-rate mortgage," he said. "To the degree that
households are driven by fears of payment shocks, but are willing to manage their
own interest-rate risks, the traditional fixed-rate mortgage may be an expensive
method of financing a home."

Lenders were happy to hear Greenspan encouraging consumers to "manage their

own interest-rate risks." Mortgage companies began offering innovative ARMs, that
previously had been pitched to the rich, to ordinary people . That includes option
ARMs -- adjustable-rate mortgages that let borrowers choose how much to pay each
month.

Four choices with option ARMs

Typically, consumers have four options each month:

• The biggest payment is on a 15-year payoff schedule.

• The next-biggest payment is on a 30-year payoff schedule.
• Then there is an interest-only payment based on a 30-year payoff schedule.
• The smallest payment doesn't necessarily cover all the interest accrued during
the month. In this "negative amortization" option, the borrower owes more at
the end of the month than at the beginning, even after making a payment.

These flexible loans are well-suited to homeowners who have irregular incomes, such
as salespeople on commission or investment bankers who earn a nominal salary and
get most of their income in an annual bonus. But option ARMs have spread beyond
those types of borrowers. Hard numbers are difficult to come by, but option ARMs are
much more popular now than they were 18 months ago.

In a widely cited report this spring, an analyst for UBS said more than half of
borrowers who took out option ARMs in 2004 were making the minimum payments
this year. Testifying to the Senate in July, Greenspan connected the dots, saying that
the loans "are being used to enable people to purchase homes who would otherwise
not have been able to do so." That's a bad reason to get one of these loans, he
added.

When the Fed chairman made those remarks, none of the senators pointed out that,
just 17 months earlier, Greenspan had encouraged homeowners to get ARMs and had
chastised lenders for not offering enough alternatives to fixed-rate mortgages.

Risks vs. benefits

Lenders fume at Greenspan's backtrack and at the skeptical press that alternative
mortgages have been getting lately. "As much as people want to vilify the mortgage
industry, we're not idiots," says Walters. "Yes, there are risks -- but there are also
benefits. Would you like to focus on the risks or focus on the benefits?"

The main benefit of the option ARM is its flexibility, allowing the borrower to make
tiny payments when money is tight. Sophisticated borrowers can make minimum

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payments and invest the rest. And, as Greenspan noted, some borrowers use the
loans to buy homes that they otherwise couldn't afford.

Option ARMs carry two primary perils. First, they allow people to sink a minimal
amount of money in property that is expected to grow in value, resulting in a great
return on investment. "But," Fed Governor Mark Olson said in a speech in June, "to
the extent that these new mortgage products promote home-buying decisions that
are premised on unrealistic rates of home appreciation, they raise concerns."

Payment shock
The other major risk of an option ARM comes from payment shock. Under certain
conditions, the minimum monthly payment could more than double from one month
to the next. Fitch Ratings established a pessimistic scenario in which the minimum
payment on a $500,000 loan jumps from $2,148 one month to $5,548 the next.
Such an outcome is unlikely, but possible if someone makes only minimum payments
for five years while rates rise.

"There are risks, but they're far less dramatic than the hype of recent months," says
Doug Duncan, chief economist for the Mortgage Bankers Association. "Innovative
mortgage products have allowed a lot of consumers to become homeowners.
However, borrowers need to realize that they're increasing their risk exposure with
some types of products."

The Mortgage Bankers Association just released its own study of what it calls
"innovative mortgage products." The 30-page report acknowledges that option-ARM
borrowers might default more often but says lenders are giving homeowners what
they want. "Borrowers need to be vigilant to be sure that they are prudently
managing the incremental risk that these innovative new products represent," the
report says.

There's that word again: risk.

How option ARMs work

Option ARMs have complex structures, making them hard to understand. Don't get
one unless the lender has explained the risks you take under various scenarios. Ask
what would happen if rates rise rapidly and steadily for several years, or what would
happen if rates seesaw.

Most option ARMs are based on one of three indexes: the 11th District Cost of Funds
Index (the COFI), the 12-month moving Treasury average (the MTA), or the one-
month London Interbank Offered Rate (the 1-month LIBOR). All of these move up
and down roughly together, but the COFI has the smoothest ups and downs, the
LIBOR is the most volatile (sometimes rocketing upward or plunging downward in
just a month or two) and the MTA lies in the middle. Bankrate tracks these rates
weekly in its "Rate Watch" section.

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The rate on an option ARM is adjusted monthly, but the minimum payment is
adjusted annually and remains fixed for a year. If rates rise afterward, the minimum
payment doesn't cover all of the interest charged. When that happens, you owe more
on the mortgage at the end of the month than at the beginning of the month, even
after making that minimum payment. This phenomenon is called negative
amortization.

'Recasting' the loan

On most option ARMs, the minimum payment can't be increased by more than 7.5
percent per year. That cap is lifted after five years when the loan is "recast," and the
minimum payment can skyrocket. Minimum monthly payments also can jump
dramatically if the loan balance hits a negative amortization cap of 110 percent to
125 percent of the original loan amount.

In a research paper for investors, Fitch Ratings (registration required) calculated a

scenario in which a borrower gets a $500,000 option ARM, and the interest rate rises
from 5.41 percent to 9.66 percent in five years. The minimum monthly payment
would be $2,148 in the 60th month. Then the payment cap would be removed. The
next month, the minimum payment would jump to $5,548. That's a $3,400 increase
in minimum monthly payment.

Negative amortization in action

The seeds for this bitter harvest are planted in the first month. The loan in Fitch's
scenario has a teaser rate of 1 percent that lasts just for that first month. The rate
rises to 5.41 percent in the second month. Meanwhile, the minimum monthly
payment for the first year is based on a 1-percent loan. But that $1,608 payment
doesn't even cover the interest, which is $2,247 in the second month. After making
the minimum payment, the amount owed rises $639 in just the second month. That's
negative amortization in action, and the amount owed rises every month that the
borrower makes the minimum payment.

The researchers looked back at option ARMs underwritten from 1994 to 2004 and
discovered that during some periods, the majority of borrowers were making the
minimum payments. But by the end of the fifth year, most borrowers were making
more than the minimum payments. On the other hand, option ARMs were marketed
to a wealthier, financially sophisticated borrower before 2004.

Fitch's researchers concluded that "borrowers who actively manage their finances,
expect to refinance or move within a short time, or have the financial wherewithal to
cope with higher payments" will be less likely to get in trouble than "a borrower who
is looking to purchase a home he or she otherwise could not afford with a 30-year
fixed-rate mortgage."

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