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2006: A look back - A look ahead  
  Mortgage rates and home prices rose in 2006 while a refi boom is anticipated in 2007.
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5 ways to assess risk of your option ARM

On the other hand, "most regular people who have a regular-paying job do not belong in a loan like that," Ohlbaum says. "They're going to get in trouble."

To stay out of trouble, there are a number of things you can do if you have an option ARM: Make at least the interest-only payment, refinance the loan or sell the house and pay off the mortgage.

By making the interest-only payment, you're at least treading water instead of sinking under the waves. You're not paying down principal but you're not adding to it, either. As rates rise, the interest-only payment rises.

"If you got this loan a year ago and you can make the payments the next couple of years, just keep an eye on it," Lefanowicz says. "Don't panic."

Time for plan B?
But if you can't handle interest-only payments, it's time for plan B.

Plan B is refinancing the loan. If your current lender did a lousy job of explaining an option ARM, you'll probably want to avoid refinancing with that lender. "My best advice you can do is go to someone like us," E-Loan's Lefanowicz says. "Our loan consultants don't get paid more for giving the customer a higher rate."

You will want to talk to your current loan servicer to find out if there's a prepayment penalty and how much it would cost. Most option ARMs have prepayment penalties, which you are charged if you refinance the loan or sell the house within a specified period, usually one to three years.

Ohlbaum has a client who wants to refinance his $450,000 option ARM. It has a 2 percent prepayment penalty, which means the borrower has to shell out $9,000 just to refinance. But the rate on the option ARM is 1.25 percent higher than what he could get on a 30-year fixed, and he will be able to save about $450 a month by refinancing. He will break even in about 20 months.

"You kind of have to go, 'OK, I made a mistake. Let me get out sooner rather than later,'" Ohlbaum says.

Or maybe plan C?
Then there's plan C: selling the house and paying off the loan. The main reason to do this is that you've looked at your finances and you realize that you bought too much house. You just can't afford your house and achieve your other financial goals at the same time. In other words, you live in California (only half-kidding).

You're an especially suitable candidate to sell the house and pay off the option ARM if house values are falling in your neighborhood. Unless you know that you can sit tight for five or six years while prices fall, stagnate and then rise, it's probably a good idea to test the real estate market.

-- Updated: Nov. 1, 2006
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