Buyers should beware of the 'option ARM' and its tricky aspects

Published October 2, 2006

The riskiest of the adjustable- rate mortgages is something known an "option ARM," which gives buyers a choice of monthly payments.

Most option ARM borrowers opt for the minimum monthly payment, which is so low it doesn't cover the full interest due. The unpaid amount is added to the principal of the loan. Instead of shrinking, the mortgage gets bigger every month, something known as negative amortization.

This is a particularly dangerous situation in a time of stagnant or falling home prices. Borrowers can easily end up owing more than the house is worth, which means they can't sell it without writing a check at the closing.

These mortgages have several tricky aspects that many borrowers don't fully understand. For starters, the advertised rate - sometimes less than 2 percent - is typically the rate used to calculate the minimum payment, not the interest rate being charged. The minimum payment may stay the same for the first year, but the real interest rate adjusts every month.

"What I don't like about this loan is how quickly the interest rate has been increasing and how easy it is not to notice this," said Sarah Murphy, 44, a Gulfport real estate broker and rental property investor. She said that in just five months, the interest rate on one of her loans has risen from 6.86 percent to 7.44 percent.

"If I continue to make only the minimum payment, a loan of $85,000 at the end of the year will have a balance due of $86,722," she said. "I could end up owing more than the property's value."

But low minimum payments don't last forever. The minimum payment adjusts each year. Murphy said that on one of her loans, the minimum payment went from $489 last year to $566 this year.

Payments on option ARMs can skyrocket if the loan reaches a preset cap, which typically is 115 percent of the original loan value. At that point, the borrower is required to pay the full interest amount plus some principal.