About Option ARM

Interest-only mortgages have gotten a lot of ink lately, but there's another type of potentially risky home loan that deserves even more scrutiny, according to some in the real estate industry.

Known as an option ARM, it's an adjustable-rate mortgage that typically lets borrowers choose one of four different payments each month. From smallest to largest, they are: a minimum monthly payment, an interest-only payment, full principal and interest amortized over 30 years, or full principal and interest amortized over 15 years.

Those who choose the interest-only payment pay no principal that month, but they pay the full amount of interest due, so their loan balance stays the same.

Those who choose the minimum payment pay no principal, and less interest than what accrues on the loan. The unpaid interest is added to the loan balance, resulting in what's known as negative amortization.

If borrowers continue to make the minimum payment, their loan balance will grow, and if interest rates rise, it will grow even faster, up to a point. When the balance reaches a certain point -- usually 110, 115 or 125 percent of the original balance, depending on the loan -- the loan is "recast" and the minimum payment goes up.

Option ARMs are the reincarnation of negative amortization loans, which were popular in the 1980s (especially in Texas and the Southwest) but fell out of favor in the early 1990s, when interest rates shot up and home prices fell in certain areas, leaving some borrowers owing more than their homes were worth, according to Keith Gumbinger, a vice president with HSH Associates.

Option ARMs are newer than interest-only loans, but growing fast. In 2004, they accounted for about 5 percent of all home loans that were securitized, or packaged and sold to investors, according to Fitch Ratings.

Interest-only loans accounted for about 31 percent of all new mortgages last year, but David Lareah, chief economist with the National Association of Realtors, says he is more worried about option ARMs than interest-only loans.

"They are a lot more dangerous," he says, because "the borrower is giving away part of his equity," sometimes unknowingly.

Although the loan documents disclose the risks, the marketing materials are not always forthcoming. "The brochure starts out by saying, 'Here is your monthly payment.' It looks so low, you make an appointment, go to the lender," Lareah says. "They have to tell you eventually it's negative am, but by the time they tell you, you are emotionally into it."

The loans are often pitched as a good option for people with variable incomes -- such as the self-employed and those who get year-end bonuses -- because they can adjust their monthly payments.

But they are also being used by people to buy more house than they could otherwise afford, causing some concern that they could default if interest rates should rise.

"Clearly, some people use it as an affordability product," says Mark Douglass, a senior director with Fitch Ratings, which evaluates mortgage- backed securities.

Fitch has found that on average, roughly half of the people with option ARMs tend to "negatively amortize" during the first five years, meaning they pay less than the interest-only amount, thereby adding to their mortgage balance. About 10 percent pay the interest-only amount and the rest make a fully amortizing payment.

After the first five years, very few amortize negatively, Douglass says. He says option ARMs can be risky but in certain cases, less risky than interest-only loans. A new Fitch study measures risk based on the "payment shock" borrowers would experience if interest rates rise by certain amounts.

With an option ARM, the potential payment shock depends on three things: the interest-rate index, the teaser rate and the negative amortization balance cap (or how much the balance can exceed the original balance).

Most option ARMs are tied to either the moving Treasury index, the 11th District Cost of Funds Index (COFI) or the London Interbank Offered Rate (LIBOR).

The fully indexed rate is some margin, typically two to three percentage points, above the index.

A lower rate, known as the initial or teaser rate, is used to calculate the first month's payment, and the minimum monthly payments for the first year. Teaser rates are usually 1 to 2 percent.

The teaser rate sets the minimum payment, not the total payment. The total payment (starting in month two) is based on the fully indexed rate.

If borrowers make the minimum payment, the difference between it and what they would have paid at the fully indexed rate is added to the balance.

Gumbinger of HSH gives this example:

Suppose you borrow $400,000. The fully indexed rate is LIBOR plus 2.5 percent. The teaser rate is 1.5 percent. The balance cap is 115 percent of the original loan. The minimum payment for the first year would be about $1,380 per month ($400,000 at 1.5 percent).

The interest-only payment -- based on a fully indexed rate of 5.63 percent -- would be $1,875 in the second month. (This amount will go up and down each month, with LIBOR.)

If the borrower makes the minimum payment, the difference between it and the interest-only payment -- about $495 the second month -- is added to the balance.

If the borrower wanted to make a full principal and interest payment, it would be $2,303 (based on a 30-year payoff) or $3,295 (using a 15-year payoff) in the second month.

In the second year, the minimum payment can go up by a maximum amount, typically 7.5 percent. But the loan continues to accrue interest at the fully indexed rate. If the loan builds up so much negative amortization that the balance reaches 115 percent of the original amount ($460,000 in our example), the lender will start demanding higher payments to eliminate the negative amortization.

These are the bare basics of option ARMs. There are more features that make them nearly impossible to compare lender to lender. (For details, go to mortgage-x.com/library/option_arm.asp.)

Getting back to payment shock, Douglass says that the lower the teaser rate, the higher the potential increase in monthly payments if interest rates should rise.

Option ARMs that are tied to the moving Treasury index or the cost of funds index, which are lagging indicators, will be less volatile than ones tied to LIBOR, which is a faster-moving index.

The former types "are less likely to breach their negative amortization balance cap" quickly and require higher payments, says Douglass.

Loans with lower balance caps are less risky than ones with higher balance caps because they allow the borrower to dig a smaller hole.

Douglass says option ARMs certainly can be more risky than interest-only loans, "but they are not in all cases."

Most interest-only loans are also adjustable rate, but the rate can be fixed for an initial period, such as five years. After five years, the interest rate is reset at prevailing rates, and principal payments also begin, amortized over the remaining period of the loan. If interest rates have risen over five years, borrowers can face a double whammy. In some cases, this payment shock could exceed the shock from one of the more conservative option ARMs, Douglass says.