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5 ways to assess risk of your option ARM

"It's a monthly toll," says Bob Moulton, president of Americana Mortgage, a brokerage on Long Island, N.Y. He sees option-ARM borrowers fretting over the monthly rate increases and wondering where it will lead.

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"I mean, they're angsting over this change happening each month. This is what I'm seeing," Moulton says. "The worst is if you have that and the home equity (loan) on top of that. You see that going up every month and you're dying."

4. You're approaching the principal cap.
When you make the minimum payment, and the loan balance increases, that phenomenon is called "negative amortization."

Lenders won't let negative amortization go on forever. They set principal caps -- limits on how far negative amortization can go. Most option ARMs have a principal cap of 110 percent, meaning that if your loan balance reaches 110 percent of the initial loan amount, you'll suddenly have to start paying down the loan balance.

Before you reach the principal cap, the minimum monthly payment can rise only a maximum of 7.5 percent a year. After you reach the principal cap, that limitation is thrown out the window. The minimum monthly payment can more than double in some cases.

The monthly billing statement should tell you the current balance. The promissory note will spell out the initial loan amount.

5. House prices in your neighborhood are falling.
The danger with falling houses prices is that your home's market value could fall below the amount you owe on it. That puts you in a position where you can't afford to refinance the mortgage or sell the house unless you have enough cash lying around to make up the difference. And if you have that much cash, why are you in over your head with your mortgage?

"Basically, what you're going to have on a lot of those pay option ARMs is you're going to see a lot of customers giving the keys back," says Mark Lefanowicz, president of E-Loan.

Lefanowicz says E-Loan has underwritten 60 or 70 option ARMs in the past year, a small number that reflects that "it's just not the right option for a lot of people."

What to do if you have an option ARM
Lots of people are fine candidates for option ARMs. The loans are well-suited for people whose incomes vary from month to month (think small-business owners and salespeople on commission) and people who get a big chunk of their income via bonuses (your boss's boss's boss, investment bankers and sundry corporate chieftains).

Ohlbaum says he has a client who gets half his income from an annual bonus. He pays the minimum amount most of the year, and then pays back all the negative amortization with one huge payment. "It makes perfect sense for the right guy, and he's the right guy," Ohlbaum says. And if you're like that guy, an option ARM probably won't hurt you.

-- Updated: Nov. 1, 2006
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