Option ARMs have benefits and also risks
By Holden Lewis • Bankrate.com

Consumers increasingly bear risks that lenders once carried, with the federal government encouraging the trend. Exhibit A: the popularity of the adjustable-rate mortgages called option ARMs. These mortgages bestow benefits if you use them right, but they can put you in financial peril by hitting you with a giant payment increase.

Get an option ARM only if you comprehend how it is structured and understand the risk you are taking.

"These things are tools," says Bob Walters, chief economist for Quicken Loans. "Is a chainsaw a good thing or a bad thing? If you're cutting down a stand of trees, it's a good thing. If you accidentally chop off your finger, it's a bad thing."

The head of the nation's central bank virtually told mortgage lenders to load their shelves with chainsaws a year and a half ago. Lenders heeded his call. Now Federal Reserve Chairman Alan Greenspan worries about an epidemic of severed fingers.

Speaking before the Credit Union National Association, on Feb. 23, 2004, Greenspan lamented that not enough people had taken out adjustable-rate mortgages, or ARMs, in previous years.

ARMs have lower rates than fixed-rate loans. The reason: With an ARM, the borrower risks higher payments if rates increase. With a fixed-rate mortgage, the lender risks getting stuck with a low-yield investment if rates rise.

Greenspan was a fan
About two-thirds of homeowners get fixed-rate mortgages, paying a higher rate so the deep-pocket lender takes the risk. In his speech in 2004, Greenspan complained that a lot of those borrowers wasted money by spurning ARMs.

"American consumers might benefit if lenders provided greater mortgage-product alternatives to the traditional fixed-rate mortgage," he said. "To the degree that households are driven by fears of payment shocks, but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."

Lenders were happy to hear Greenspan encouraging consumers to "manage their own interest-rate risks." Mortgage companies began offering innovative ARMs, that previously had been pitched to the rich, to ordinary people . That includes option ARMs -- adjustable-rate mortgages that let borrowers choose how much to pay each month.

Four choices with option ARMs
Typically, consumers have four options each month:

• The biggest payment is on a 15-year payoff schedule.
• The next-biggest payment is on a 30-year payoff schedule.
• Then there is an interest-only payment based on a 30-year payoff schedule.
• The smallest payment doesn't necessarily cover all the interest accrued during the month. In this "negative amortization" option, the borrower owes more at the end of the month than at the beginning, even after making a payment.