What is this 1% loan anyway?

Debunking the Negative Amortization Adjustable Rate Mortgage

Without question, loans that have the potential for negative amortization (Option ARMs) are the most complicated and sophisticated mortgage programs available in today's marketplace. So how can you be certain that you really understand this product, and how can you be sure that you understand its benefits and risks?

Let's start with the benefits

The greatest benefit of the Option ARM is its flexibility and cash flow. The primary benefits are to give borrowers the choice of either deferring a portion of their interest to achieve financial goals faster or to help real-estate investors increase their cash flow.
That said, with flexibility comes responsibility. The terms and conditions of Option ARM contracts vary widely from one investor to the next. Structured responsibly, the Option ARM offers advantages over traditional programs. Structured poorly, you have a recipe for financial stress.

The right candidates for Option ARMs

There are two types of clients who are most appropriate for Option ARMs:
  • Homeowners who leverage the reduced monthly payments so they can invest the monthly savings in an asset accumulation account. If the homeowner invests properly and profitably, it is possible to reduce the number of years it would take to achieve their financial goals
  • Homeowners who have a short-term need to keep their payments lower. Examples would be real-estate investors and people in transition who either plan to move within 2-3 years, or who need a bridge loan until they sell another property, and will refinance once they get the cash from the other property. Also self-employed or commission-only people who need flexible payment plans.

Who are NOT the best candidates for Option ARMs?

  • Homeowners who plan to be in their home for the long-term and select an Option ARM for the low monthly payment, but don't invest the difference.
The most common mistake is thinking that the start rate is the interest rate. There is a difference between the pay rate and the fully indexed rate (also known as the effective rate). The pay rate is used only to calculate the minimum payment. The interest rate is actually the combination of the index plus the margin. The difference between these two determines the unpaid interest and generally causes negative amortization. The minimum payment is generally determined by the start rate. Most tend to range between 1% and 1.95%. Although this minimum payment can be for as little as 12 or as many as 60 months, the underlying interest rate, also known as the fully indexed or effective rate, may be fixed for only one to three months, or sometimes just one day.
  • For example, for the one-month MTA, the start rate may be a fully amortized principal and interest payment for one month, and then the rate goes to index plus margin.
Let's examine a scenario, where the initial payment of 1.25% is fully amortized for one month, with the minimum payment due of $1,300; then in the second month, the interest rate of 5.59% (index plus margin) begins and the interest owed for the second month is actually $1,800.

Because the minimum payment of $1,300 is not enough to cover the interest owed, the resulting shortage in payment is added to the loan amount, making the following month's balance $500 higher.
  • Since the interest rate fluctuates monthly, the spread between the pay rate and the interest owed will change accordingly. The difference between the interest owed monthly and the payment is what is deferred and added to the top of the loan balance as accrued "unpaid interest."
  • All Option ARM loans have a maximum loan balance. Depending on the investor, it can be anywhere from 110% of the original loan amount up to 125%. If the loan were to hit this maximum balance, it would automatically recast itself with no payment options other than the fully amortized principal and interest payment.

There are at least two other payment options we will consider here:

1. An Interest Only payment is also available to the borrower as a payment option.
2. Fully amortized principal and interest payments are also an option. If this payment option is chosen, the loan essentially becomes a typical ARM, allowing your client to make a payment that will fully amortize the loan in 15 to 30 years, or any other term that the borrower prefers.

The borrower should select a mortgage originator who has the ability to help you better understand the mortgage industry's most sophisticated mortgage program, the Negative Amortization Adjustable Rate Mortgage, or The Option ARM.

     Jeff Kutnick
     President First Rate Lending