It amazes me that almost 1 year since the implosion of American Home Mortgage (that king of the pay option arm) that Wachovia was still offering their version of a "Pick-a-Pay" loans. Today, Wachovia finally stopped offering these destructive loans. Yes those famous loans with those tantalizing minimum payments that don't even cover monthly interest on the loans. In fact, with every payment your balance grows until in most cases your loan recast. This spells doom for homeowner and ultimately leads to high foreclosure rates among loan holders.
Below I will try to define some of the terms associated with a pay option Arm.
Option ARM loans have four major types of payment options:
* Minimum Payment
With the minimum payment option, your monthly payment is set for 12 months at your initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year.
If you make the minimum payment after the end of your initial interest rate period, which usually holds only for the first 1 to 3 months, it may not be enough to pay all of the interest charged on your loan for the previous month and the unpaid interest will be added to the principal balance you owe (will be deferred).
* Interest-Only Payment
With the interest-only payment option, you can avoid deferred interest, when the minimum payment is not enough to pay the monthly interest due. The interest-only payment option, however, is not available if the interest-only payment would be less than the minimum payment. Please note, that this payment option does not result in your principal reduction.
The interest-only payment may change every month based on changes in the ARM index used to determine your fully indexed rate.
* Fully Amortizing 30-Year Payment
With fully amortizing payments, you pay both principal and interest and keep your loan on schedule. Your payment is calculated each month based on the prior month's fully indexed rate, loan balance and remaining loan term.
* Fully Amortizing 15-Year Payment
If you prefer to put your loan on an accelerated schedule and can afford higher monthly payments, the 15-year payment option allows you to repay your loan twice as faster and save more than half the total interest costs of a 30-year loan.
There are many variations of this innovative home financing product on the market: PayOption ARM, CashFlow Option Loan, 1-Month Option ARM, Flex 5 Home Loan, Pick-a-Paymentsm Loan, 12 MAT ARM, Option Power ARM, FlexPay® 12 MAT, FlexPay® 3/1 LIBOR ARM, OptPAY ARM, etc.
Option ARM loan programs vary in the initial rate, negative amortization and lifetime caps, ARM index, or optional features, however, when comparing one option ARM with another, pay close attention to the margin and the fully indexed rate. Keep in mind that the initial interest rate holds only for the 1st month. This is how so many homeowners got tricked into the loan.
Loan Term
Option ARM loans are available for 40, 30 or 15 years.
Initial Interest Rate (Note Rate)
Your Minimum Payment Rate or 'Start Rate'. It may vary from 1.25% up to 3.95% and depends on your Loan-to-Value Ratio (LTV).
With hybrid option ARMs, that use a different minimum payment calculation method, your initial rate is usually higher.
Initial Interest Rate Period (Introductory Period, Initial Fixed-Rate Period)
Option ARM loans are available with an initial introductory period, usually of 1, 3 or 6 months, after which the interest rate may change.
Notes:
* Some option ARM were offered without any introductory period, so the fully indexed rate (FIR) is effective immediately.
* The initial Fixed-Rate Period should not be confused with Initial Fixed-Rate / Fixed-Payment Period, a typical feature of hybrid option ARMs.
Examples:
* With 1-month option ARMs that have a 1-month introductory period, the first interest rate change occurs when the 1st monthly payment is due. Thereafter, the interest rate may change monthly.
* If you have a 1-month option ARM loan with a 3-month introductory period, the first interest rate change occurs when the 3rd monthly payment is due. Subsequent interest rate changes may occur each month thereafter.
During the introductory period: After the introductory period:
Monthly Payment = Minimum Payment
Interest Rate = Start Rate
Monthly Payment = Minimum Payment
or Interest-Only Payment
or Fully Amortizing 30-Year
or Fully Amortizing 15-Year
Interest Rate = Fully Indexed Rate
What is a Recast? A feature in some types of mortgages where the remaining scheduled principal and interest payments are recalculated based on a new amortization schedule. Some mortgages may allow for a recast in order to help a financially distressed borrower, in which case the interest rate might be reduced and/or the remaining term of the mortgage extended. Most often, a recast is associated with a negative amortization mortgage which must recast at some point so that the mortgage will be paid off by the end of its scheduled term.
Investopedia Says... Payment option ARMs are popular negative amortization mortgages with recast features. Most payment option ARM’s have a scheduled recast in month 61. Additionally, they have triggers that might cause an unscheduled recast to occur if a negative amortization limit is reached. For example, if the principal balance of the loan reaches a set limit through negative amortization, a recasting of the mortgage is triggered.
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