| How about a mortgage with an interest rate as | | | | Amortization Period: The actual number of years |
| low as one or two percent? Wow! The payment | | | | it will take to pay a loan in full. |
| on an adjustable rate mortgage may sound great | | | | Negative Amortization: The increase in mortgage |
| but as the old adage goes: if it sounds too good | | | | debt resulting from the difference between the |
| to be true, it probably is. | | | | fully indexed rate and the payment rate (i.e. loan= |
| At the time this article was written, the Federal | | | | $300k, payment rate =1%, fully indexed rate = |
| Government borrowed money at 4.64% APY for | | | | 7%, then at the end of one year NEG AM could |
| a one month term, so can an individual | | | | = $300k * (7% - 1%) = $18k and your loan at |
| homeowner borrower money at a rate lower | | | | the end of the year = $318k). |
| than our government? The simple answer is no. | | | | These are the basic terms that need to be |
| Can this still be a good loan? Yes, for a select few | | | | understood to begin to estimate the risk and |
| who understand how it works. The remainder of | | | | rewards of an Option ARM. There are also |
| this article will cover the basic questions you | | | | payment and rate adjustment caps that offer |
| should ask when considering the negatively | | | | some additional protection for the borrower. The |
| amortizing loan commonly referred to as an | | | | Option ARM is an extreme way of leveraging real |
| Option ARM. | | | | estate and managing cash flow. Theoretically, the |
| First, let's define some important terms. | | | | borrower is making a rate of return higher than |
| Payment Rate: The percentage rate used to | | | | the rate of negative amortization. If this is the |
| calculate your minimum monthly payment. It is | | | | case then the Option ARM works well for that |
| typically the artificially low rate of 1 to 3% (or any | | | | borrower. Another suitable fit for this loan type is |
| rate equal to or lower than the One Year T-Bill | | | | a borrower that will experience a dramatic |
| rate: currently 5.23%) that is being advertised by | | | | increase in his income in a few years and the |
| your lender. Remember that the government | | | | monthly savings are more precious at this present |
| borrows money at what is called the "risk free" | | | | date. |
| rate and everyone else pays a higher rate that | | | | The sad reality is that some lenders market the |
| reflects a "risk premium". | | | | Option ARM as if that low, low payment rate is |
| Index: The particular statistical indicator tied to | | | | the actual interest rate and applicants flock to this |
| your loan. This value may rise or fall over time | | | | type of financing without a true understanding of |
| and this may in turn raise or lower the interest | | | | negative amortization. Even worse is the lack of |
| rate on your loan. Some examples of indexes for | | | | understanding by many participants in the |
| the Option ARM are the Monthly Treasury | | | | mortgage industry. Inherent in the Option ARM is |
| Average (MTA) or the Cost of Funds Index | | | | the pre-determined limit to the amount of |
| (COFI). | | | | negative amortization permitted. That limit may |
| Index Value: This is the numeric value of your | | | | be anywhere from 10% to 25% of the original |
| index today. You can check the value of the | | | | loan balance. Regardless of any payment or rate |
| index in the Wall Street Journal or other similar | | | | caps, when the negative amortization increases |
| publication at any time on your own. | | | | the mortgage balance to that pre-determined |
| Margin: This is a numeric value that does not | | | | threshold then all bets are off. The borrower can |
| change over time. It is important to note that | | | | no longer pay that low, low payment rate. The |
| your margin is negotiable. A big mistake that | | | | borrower will also no longer have the option of |
| borrowers make in obtaining an Option ARM is in | | | | paying an interest-only payment. The borrower |
| failing to negotiate the margin. | | | | will then be faced with having to pay a fully |
| Fully Indexed Rate: Now we are finally getting to | | | | amortizing payment at the fully indexed rate. In a |
| the real interest rate you will be paying on your | | | | worse case scenario, this could result in an almost |
| loan. The index value plus the margin equals your | | | | tripling of the minimum payment required before |
| fully indexed rate. This rate may be 7%, 8% or | | | | the end of the second year. |
| higher. | | | | |