Question:

Where to find information about Option ARM and interest only home mortgage loans and how best to shop for those?

Answer:

It might be useful to read about traditional fixed and adjustable rate, Option ARM and interest only home mortgage loans on the Federal Reserve Board. The information provided is enough to get you to understand how your loan will be repaid over the years.

Below follows summary of how exactly these two types of loans are more special than the others and some possible complications that may arise.

Why are Option ARM and Interest-Only home mortgage loans different from the standard fully amortizing fixed and adjustable rate mortgages?

Home mortgages with minimum and interest only options lower your monthly payment significantly for as long as this option is available. However, though, they may carry a risk to the borrower when the monthly payment has to adjust to fully amortizing monthly payments.

Basically, Option ARMs allow your original loan amount to grow (this is called negative amortization) until it reaches 105% to 125% of the original loan amount, as set forth by the lender. IO home loans avoid negative amortization, but they also allow substantial increase in the monthly payment after the I-O payment period is over, if the loan is not paid off or refinanced until then.

Option ARMs can be riskier than Interest Only home mortgages.

Option ARMs are structured to allow a choice among 3 basic payment options for usually up to 5 years, or until the principal reaches the loan cap.

  • Very low monthly payments. Minimum only; can be as low as 1-1.25%. Minimum only payments add up to your principal balance what is the difference between minimum payment and the interest due for the month.
  • Interest-only payments require that you pay what is the effective Fully Indexed Rate (FIR) of the loan.
  • Fully amortizing monthly payments. Those can be scheduled for 15, 30 or 40-year mortgage terms.

Option ARMs are adjustable rate loans. IO mortgages can be fixed or adjustable rate, too. Fixed IO mortgages carry lower risk to the borrower, as you can see exactly how much your payment will be after the I-O option is exhausted, but they have higher rate than the standard FRM loan and the cash savings are not nearly as huge as with Option ARMs, or with adjustable rate IO home mortgages.

Option ARM monthly payment can grow much larger than Fixed Rate Interest Only mortgage loan monthly payments.

That is why borrowers often tend to take an Option ARM, lured by the low starting interest rates and monthly payments. However, some consumers simply do not understand how these loans work and some loan officers would make use of it and sell a loan to people it is not intended for. This is how subprime Option ARM foreclosure rates got so high.

Do not go after Option ARM if you don't exactly understand what the risks are. And they are twofold:

  1. Your loan balance is very likely to go up. 10% is a common loan increase cap. On a $400,000 loan that means your loan principal can grow up to $440,000.
  2. On top of that your effective interest may easily double up and reach 10% with common yearly 7.5% cap increase that may or may not exist on your payment.

Here is an example how your monthly payment can change with an Option ARM:

If your minimum only payment is 2% on a 30-year $400,000 Option ARM and the effective rate is 5% with recast at 110% or after 5 years, your initial payment may be as low as $1,478.48. If the Option ARM is fixed rate for 5 years, your payment stays the same for 5 years as the loan cap won't be reached in 5 years.

However, if the effective mortgage rate is scheduled to adjust every 6 months, your payment may grow up to $2000 within the 5-year period and you will still be making the minimum payment and the loan principal will grow. Your loan payment will start rising even more after the recast occurs.

Advice:

If you are taking the Option ARM or Interest Only home loan just to be able to afford more house and you are not a financial savvy individual and no investor, use professional advice. Thus, you will know better how long to keep the loan and whether to refinance if necessary. And there will be fewer surprises on the monthly payment increase.

Comparing IO and Option ARM features is particularly complicated to do it on your own. Find an Upfront Mortgage Broker (UMB) to work with you on exclusive terms. This may cost you additional upfront loan costs which, however, usually can be rolled into the loan and in the long run will save you tens of thousands and prevent possible mortgage default.

Mortgage rates hit their lowest since 1955. Ask the home loan experts we recommend Quicken Loans how to take advantage of them.
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