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5 ways to assess risk of your option ARM

A mortgage called the option ARM offers a tantalizing possibility: The minimum payment is so low that you owe more on the house at the end of the month than at the beginning.

If you read Norton Juster's "The Phantom Tollbooth" as a kid, you're familiar with the concept. As the characters dine on a concoction called "subtraction soup," they become hungrier by the spoonful. They feel ravenous at the conclusion of the course.

An option ARM is like subtraction soup, except that a steady diet of minimum payments can result in a feeling of homelessness instead of hunger. To pile on the alarming rhetoric, a recent cover story in BusinessWeek dubbed the option ARMs "nightmare mortgages" and called them "toxic" and "deceptive."

Payment option adjustable-rate mortgages are appropriate for some borrowers in certain circumstances, and they're dangerous for other people.

Assessing your risk
If you have an option ARM, there are ways to assess your risk and steps to take. Here are some risk factors to watch for:
5 risk factors
1. You don't understand how an option ARM works, but you have one anyway.
2. You exaggerated your income on your application.
3. You regularly have been making minimum payments.
4. You're approaching the principal cap.
5. House prices in your neighborhood are falling.

1. You don't understand how an option ARM works, but you have one anyway.
Mitch Ohlbaum, president of Legend Mortgage in Los Angeles, bemusedly pages through the BusinessWeek article that calls option ARMs nightmare mortgages.

"They're nightmares to the extent that people don't have them explained," Ohlbaum says. "I get calls all the time from people who say, 'I took this loan, I didn't understand it, my rate keeps going up. No one explained it to me."

Option ARMs are hard to describe. Mortgages lie on a spectrum from the fairly simple to the sublimely complex, like the math taught from first grade through college. Fixed-rate loans are like basic arithmetic. Adjustable-rate mortgages are like algebra. Option ARMs are like calculus. Plenty of homeowners are furrowing their brows in calculus class when they should be memorizing their multiplication tables.

An option ARM is an adjustable-rate mortgage that gives the borrower four choices of a payment each month. The borrower can pay the amount necessary to pay the loan off in 15 years or in 30 years. The borrower can pay only the interest charged in the previous month. Or the borrower can make a minimum payment that doesn't even cover the interest, so that the loan balance increases.

Most option ARMs have absurdly low introductory rates, sometimes below 2 percent, that last just a month. Then they rise. And rise. The rate changes each month, but the minimum required monthly payment changes only once a year.

-- Updated: Nov. 1, 2006
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