How The Option ARMS Work

Option ARMs have complex structures, making them hard to understand. Don't get one unless the lender has explained the risks you take under various scenarios. Ask what would happen if rates rise rapidly and steadily for several years, or what would happen if rates seesaw.

Most option ARMs are based on one of three indexes: the 11th District Cost of Funds Index (the COFI), the 12-month moving Treasury average (the MTA), or the one-month London Interbank Offered Rate (the 1-month LIBOR). All of these move up and down roughly together, but the COFI has the smoothest ups and downs, the LIBOR is the most volatile (sometimes rocketing upward or plunging downward in just a month or two) and the MTA lies in the middle. Bankrate tracks these rates weekly in its "Rate Watch" section.

The rate on an option ARM is adjusted monthly, but the minimum payment is adjusted annually and remains fixed for a year. If rates rise afterward, the minimum payment doesn't cover all of the interest charged. When that happens, you owe more on the mortgage at the end of the month than at the beginning of the month, even after making that minimum payment. This phenomenon is called negative amortization.

'Recasting' the loan
On most option ARMs, the minimum payment can't be increased by more than 7.5 percent per year. That cap is lifted after five years when the loan is "recast," and the minimum payment can skyrocket. Minimum monthly payments also can jump dramatically if the loan balance hits a negative amortization cap of 110 percent to 125 percent of the original loan amount.

In a research paper for investors, Fitch Ratings (registration required) calculated a scenario in which a borrower gets a $500,000 option ARM, and the interest rate rises from 5.41 percent to 9.66 percent in five years. The minimum monthly payment would be $2,148 in the 60th month. Then the payment cap would be removed. The next month, the minimum payment would jump to $5,548. That's a $3,400 increase in minimum monthly payment.

Negative amortization in action
The seeds for this bitter harvest are planted in the first month. The loan in Fitch's scenario has a teaser rate of 1 percent that lasts just for that first month. The rate rises to 5.41 percent in the second month. Meanwhile, the minimum monthly payment for the first year is based on a 1-percent loan. But that $1,608 payment doesn't even cover the interest, which is $2,247 in the second month. After making the minimum payment, the amount owed rises $639 in just the second month. That's negative amortization in action, and the amount owed rises every month that the borrower makes the minimum payment.

The researchers looked back at option ARMs underwritten from 1994 to 2004 and discovered that during some periods, the majority of borrowers were making the minimum payments. But by the end of the fifth year, most borrowers were making more than the minimum payments. On the other hand, option ARMs were marketed to a wealthier, financially sophisticated borrower before 2004.

Fitch's researchers concluded that "borrowers who actively manage their finances, expect to refinance or move within a short time, or have the financial wherewithal to cope with higher payments" will be less likely to get in trouble than "a borrower who is looking to purchase a home he or she otherwise could not afford with a 30-year fixed-rate mortgage."

 See the Benefits and Risks of Option ARMS.