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Risks of Option Arm Loans

Although option arm (or pay option arm) loan programs can provide many benefits for a large group of homeowners they are not without risk.  Interest rates have been low for a very long time but eventually they will rise so if you are a first time homeowner or a consumer with limited or fixed income then it is wise to understand the following risks before accepting an option arm home loan.

Negative Amortization


Owing more than your Original Loan Amount


Securing a Home Equity Loan Behind an Option Arm

These loans carry the possibility of Negative Amortization

Negative amortization arises when the mortgage payment is smaller than the interest due causing your loan balance to increase rather than decrease.  Much like a credit card if you only pay the minimum due you will most likely never see your principal balance decrease however there is also greater risk that your loan balance will grow the longer you simply pay the minimum due.

Can you end up owing more than your original loan amount?

Yes.  Absolutely, Positively Yes.

Option arm loans provide homeowners with payment options (hence the name).  One of your payment options will include a minimum payment amount that is lower than the actual interest owed.  Should  a homeowner choose to pay the lowest amount then the remaining interest will simply be added to the principal balance (negative amortization).  Ask your loan officer for a copy of the note before signing any documents.  You will usually see a clause stating in the event your mortgage balance increases above 110-125% of the initial mortgage amount the lender will have the right to recast your payments or force a principal payment in order to maintain the balance below this limit.  The following information will help you understand how the payment recasting process applies.

Negative Amortization Cap:

This cap limits the loss of equity in your home when your monthly payments are not sufficient to cover the fully indexed interest rate charges agreed upon in terms of your mortgage note.  This amortization cap is usually set to either 110% - 125% of your original principal balance.  When the negative amortization cap is reached, the minimum payment increases immediately and the payment required to fully amortize the loan over the remaining term becomes the new minimum payment.  Additionally, the safety of the payment cap will no longer apply.

Payment Recasting:

Payment Recasting (another way of simply saying re-calculating your loan payment) is a lenders way of limiting negative amortization and keeping your loan on the original payment schedule.  Option ARM and Pay Option Arm loans are recast every five years (or sooner, if the negative amortization limit is reached).  Your new payment will be based on the outstanding principal balance, the remaining term and the fully indexed rate according to your loan terms.

what about my ability to obtain a home equity loan?

It's every homeowner's responsibility to understand what lenders do at the time you originate an "Option Arm" mortgage.   Since your minimum payment could be below the actual amount of interest you owe lenders will secure a note on your home that is for more than the face value of your loan in order to protect their interest in the event your principal balance rises.  For example, if you are taking a mortgage out for 80% of a $200,000 home your loan will be for $160,000 however the lender may secure up to $160,000 X 1.25% or $200,000 of your equity.  Therefore some lenders may consider this first mortgage as counting for 100% Loan to Value making it tougher to get a home equity line.

If you are interested in obtaining a second mortgage or a home equity line it may be difficult unless you have a reasonable amount of equity in the home.  Most lenders who review your second mortgage application will consider your first mortgage balance plus the additional 25% in order to count for the first mortgage lenders rights.  It is possible to get a second mortgage behind these loans but terms can be difficult and lenders hard to find if you already owe above 90% of your home's value.  Of course, if you have 50% equity then your options will be much stronger however for first time homebuyers with minimal down payments it may be a very wise idea to consider other mortgage options before the option arm loan.

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