Pick-a-Payment
Mortgages...the Most Dangerous Mortgage Around
You probably haven't seen any advertisements
for "negative amortization mortgages" because getting a home loan is
supposed to be a positive experience. But if you've been intrigued
by promotions for "Option ARMs" or "Pick-a-Payment" mortgages, be wary.
These are usually euphemisms for negative
amortization loans - and unless you're careful they can leave you
economically depressed and possibly homeless.
What Are Option ARMs
or Pick-a-Payment Loans?
Option ARMs are
adjustable-rate mortgages with a couple of appealing features: They
usually carry initial teaser rates as low as 1%, and they offer
several alternatives for making your monthly payment.
The options include
an interest-only payment, which covers only the interest on the
loan, or a minimum payment that's even lower. The minimum payment
option, combined with the low introductory interest rates, have fueled
the growth of these mortgages in hot housing markets where even modest
homes are out of reach for the majority of buyers.
That's what has
some housing experts concerned. In the hands of sophisticated real
estate investors or wealthy individuals, these mortgages can free up
cash for other purposes. But in overheated markets, borrowers may be
using these loans to buy homes they couldn't otherwise afford.
The attractiveness of
this product is flexibility, but that flexibility sometimes can get
people in trouble.
Option ARMs present two
risks for borrowers:
•Sharply
higher monthly payments. All borrowers with adjustable-rate
mortgages face the possibility of higher payments, but borrowers with
option ARMs risk a seismic increase.
The introductory rate
usually lasts for about a month. After that, it's typically
adjusted to about 5%. If you continue to make the minimum payment, the
amount of unpaid interest is added to the balance of your loan.
But most lenders
won't let you make minimum payments forever. At some point, your lender
will "recast" the loan.
When that happens,
your monthly payments will be increased enough to pay off the interest
and principal within the remaining term of the loan.
Your lender may
recast your loan after a set period, such as five years. But if interest
rates rise, the reckoning could come much sooner. That's because option
ARMs include a cap on negative amortization, typically ranging from 110%
to 125% of the original loan balance.
When the cap is
reached, payments become fully amortizing, even if you've held your loan
for less than five years.
If you make minimum
payments for a few months, then increase them, the payment shock won't
be as dramatic. But some studies have suggested that more than half
of option ARMs borrowers are making only the minimum payments.
Some of those borrowers face a much larger payment shock than they
understand.
The lower the
introductory interest rate, the higher the payment shock. A Fitch
analysis found that borrowers with a 1% initial rate could see their
payments rise by more than 100% in less than four years.
•Negative
amortization. Some borrowers don't worry about payment shock
because they're convinced they'll move before it occurs. But negative
amortization could interfere with your plans to hightail it out of town
before your monthly payments rise.
With a traditional
mortgage, your loan balance gradually decreases. With negative
amortization, your loan balance increases. If your home value rises at
an even faster rate, you can use the profit from the sale to pay off
your loan. But if home prices in your area stagnate or decline, you
could end up owing more on your home than it's worth — a major problem
if you need to sell.
Even a small increase
in property values could leave you in the hole, because real estate
commissions and closing costs typically consume about 6% to 8% of the
proceeds.
A useful tool
An option ARM may
provide flexibility for home buyers with uneven incomes, such as those
who work on commission or receive a year-end bonus. But many homeowners
don't have the discipline to increase their payments when times are
good.
Saying you're going
to put your bonus against the balance is one thing. Actually doing it is
another. The temptation is always going to be there to find another way
to spend it.
A competent mortgage professional can be a
tremendous asset when trying to decipher the type of loan that is best
for you. The Residential Mortgage
Advocates™ listed on this site have signed a commitment to looking
out for YOUR best interests. Work with a professional that cares
about you in the present and future!
All members on this site have signed a
Residential Mortgage Advocate™ (RMA) commitment to be totally upfront about
their fees, rates and items they will need from you.
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