Option ARM Mortgages - THE WHAT, WHY & HOW

The Options Adjustable Rate Mortgage is an ARM (Adjustable rate Mortgage) like most others in its origins. It consists of taking an index, most commonly the MTA (12 month Treasury Average), CODI (Cost of Deposit Index), and COSI (Cost of Savings Index), then adding a margin to total the final interest rate.

Unlike other ARM's where the principal and interest or simple interest payment is calculated from the total of the index and margin, the Options ARM offers 4 monthly payment options every month, giving you the opportunity to choose which payment gets made based on your economic condition at the time the payment is due. This monthly payment option is where the Options ARM derives its most common name. Other names the Option ARM is known by are: Cash-Flow ARM's, Pay Option ARM's, and Pick a Payment Loans.

What are the Indexes?

There are 5 types of commonly used indices. Each index is influenced by different forces acting upon it. The thing to remember about the index is that it always fluctuates. An index never gets locked in when the loan closes, only the margin gets locked in at closing. The following is the list of each index and a brief description of how the index works:

•        MTA - The 12 month Treasury Average. It takes the previous 12 monthly values of the 1 year CMT (US Treasury Security) and averages them creating a much more stable index than the CMT itself.

•        CODI - The Cost of Deposit Index is the 12 month average of the monthly averaged yields on the nationally published 3 month Certificate of Deposit Rates.

•        COFI - The 11th District Cost of Funds Index reflects the average interest rate paid by the member banks and savings institutions located in Arizona, California and Nevada. The largest part of this index is based on savings accounts so it will move more slowly to market swings. The COFI has long been considered the most stable and popular of indices associated with the Options ARM.

•        COSI - The Cost of Savings Index is the hardest to track but arguably the least volatile. The COSI index is the weighted average of the rates of interest paid on depository accounts held with World Savings. The index is calculated at the end of every month and then averaged with the previous 12 months creating a very stable index.

USEFUL TIPS

What is the Margin? A margin is defined as the difference between the interest rate and the index on an Adjustable Rate Mortgage. The lender determines what the margin shall be at the time your loan closes. The number of percentage points the lender adds to calculate the ARM interest rate at each adjustment period (i.e. the Margin), will be locked in at closing, the index is never locked in as previously mentioned. The margin will remain fixed during the entire term of the loan and can never be impacted by upswings or downswings in the economy. The margin will be added to each adjustment period to calculate what your rate will be for that upcoming period.

What are the Payment Options?

There are typically 4 payment options to choose from each month and you actually get to elect which one you make. This is the primary advantage of choosing this type of mortgage. These options will help you better manage your monthly cash flow, and provide more liquidity in the day to day operations of the normal household. The monthly payment options you have each month will depend on which version of this hybrid loan program you have. The following is the basic options that exist:

1.       THE MINIMUM PAYMENT OPTION

2.       INTEREST ONLY PAYMENT

3.       30-YEAR PAYMENT

4.       15-YEAR PAYMENT

See an example of an Option ARM Statement

The minimum payment option is the LOWEST of the 4 payments and should be considered like a credit card payment for the simple reason that with this payment you are paying neither the principal nor the entire amount of interest due on the loan. The interest that does not get paid gets added back into the interest due on the loan and this increases your actual loan balance - This is called NEGATIVE AMORTIZATION, OR DEFERRED INTEREST.

The interest only payment - you avoid deferring interest but at the same time you are not making a principal reduction payment. This payment option is your second lowest payment type. As with most interest only payment loans, there is a clause in the mortgage note that will dictate how long you can make interest only payments.

The 30-year payment or 30-Year Fully Amortizing Payment is the regular vanilla payment most people are probably used to making with payment going towards principal and interest. Consistently making this payment will payoff the loan in 30-Years.

The 15-year payment or Accelerated Payment Option will payoff the loan in 15 Years - both principal and interest are being paid.

LIFETIME CAPS - Will set a maximum on how high your interest rate can increase over the life of the loan.

START RATES - will also vary by lender and index as well. They will typically start at 1.25% to 4.25% and are heavily influenced by how much you put down as well as your credit standing. Those with more equity may likely see a lower rate.

TERMS EXPLAINED

ADJUSTABLE RATE MORTGAGE - A mortgage loan in which the lender may adjust the rate of interest according to some specific index at periodic intervals during the loan term (ARM) Known as a variable rate in the UK.

ADJUSTMENT CAP - A limit applied to the amount of adjustment allowed in the interest rate during any one adjustment period.

AMORTIZATION - The process of retiring the principal balance during the term of the loan. A self-amortizing loan is one in which the principal is completely retired at the end of the term.

FULLY INDEXED RATE - The interest rate that can be charged on an ARM based on the current value of the index. The rate is calculated by adding the margin to the current value of the index.

INDEX - The specific indicator which governs adjustments in the interest rate on an ARM.

INITIAL INTEREST RATE - The interest rate applied to the ARM from the time it is originated until the first adjustment date.

LIFE-OF-LOAN CAP - A limitation to the amount an ARM interest rate may change from the initial interest rate over the term of the loan.

MARGIN - A constant amount added to the value of the index for the purpose of adjusting the interest rate on an ARM.

NEGATIVE AMORTIZATION - A situation in which the principal balance is increased with each monthly payment because the payment is too small to cover all of the interest due on the principal balance.

TEASER RATE - An interest rate applied to an ARM at origination that is lower than the fully indexed rate at the time. The teaser rate is effective until the first adjustment date on the ARM.

IN SUMMARY:

This loan program is not for everybody; however, for those comfortable with a little risk, in exchange for a great deal of flexibility together with the discipline to check the mortgage statement every month, this could be the right loan.

It is a great loan for someone wishing to leverage their house as an investment, and invest some of those hard earned dollars elsewhere for possibly a greater return, for example an annuity offered by a financial planner. It is also excellent for those that derive their income from commissions or any other potentially fluctuating source.