Option ARMs have complex
structures, making them hard to understand. Don't
get one unless the lender has explained your risks
under various scenarios. Ask what would happen
if rates rise rapidly and steadily for several
years, or what would happen if rates seesaw.
Most option ARMs are based on one
of three indexes: the 11th
District Cost of Funds Index (the COFI), the
12-month moving Treasury average (the MTA),
or the one-month
London Interbank Offered Rate (the 1-month
LIBOR). All of these move up and down roughly
together, but the COFI has the smoothest ups and
downs, the LIBOR is the most volatile (sometimes
rocketing upward or plunging downward in only
a month or two) and the MTA lies in the middle.
Bankrate tracks these rates weekly in its Rate
The rate on an option ARM is adjusted monthly, but
the minimum payment is adjusted annually and remains fixed for a year. If rates
rise afterward, the minimum payment doesn't cover all of the interest charged.
When that happens, you owe more on the mortgage at the end of the month than at
the beginning of the month, even after making that minimum payment. This phenomenon
is called negative amortization.
On most option ARMs, the minimum payment can't
be increased by more than 7.5 percent per year.
That cap is lifted after five years when the loan
is "recast," and the minimum payment
can skyrocket. Minimum monthly payments also can
jump dramatically if the loan balance hits a negative
amortization cap of 110 percent to 125 percent
of the original loan amount. Bankrate's Mortgage
reset calculator can help consumers predict
how the recast will affect the monthly loan payment.
In a research paper for investors,
Ratings (registration required) calculated
a scenario in which a borrower gets a $500,000
option ARM, and the interest rate rises from 5.41
percent to 9.66 percent in five years. The minimum
monthly payment would be $2,148 in the 60th month.
Then the payment cap would be removed. The next
month, the minimum payment would jump to $5,548.
That's a $3,400 increase in the minimum monthly
amortization in action
The seeds for this bitter harvest are planted
in the first month. The loan in Fitch's scenario
has a teaser rate of 1 percent that lasts only
for that first month. The rate rises to 5.41 percent
in the second month. Meanwhile, the minimum monthly
payment for the first year is based on the 1 percent
teaser rate. So that $1,608 payment doesn't even
cover the interest, which is $2,247 in the second
month. After making the minimum payment in only
the second month, the amount owed still rises
$639. That's negative amortization in action,
and the amount owed rises every month the borrower
makes the minimum payment.
The researchers looked back at
option ARMs underwritten from 1994 to 2004 and
discovered that during some periods, the majority
of borrowers were making the minimum payments.
By the end of the fifth year, most borrowers were
making more than the minimum payments. On the
other hand, option ARMs were marketed to a wealthier,
financially sophisticated borrower before 2004.
Fitch's researchers concluded that "borrowers who actively
manage their finances, expect to refinance or
move within a short time, or have the financial
wherewithal to cope with higher payments"
will be less likely to get in trouble than "a
borrower who is looking to purchase a home he
or she otherwise could not afford with a 30-year,