Option ARMs have benefits and also risks 

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 Consumers increasingly bear risks that lenders once carried, with the federal government encouraging the trend. Exhibit A: the popularity of the adjustable-rate mortgages called option ARMs. These mortgages bestow benefits if you use them right, but they can put you in financial peril by hitting you with a giant payment increase.

Get an option ARM only if you comprehend how it is structured and understand the risk you are taking.

"These things are tools," says Bob Walters, chief economist for Quicken Loans. "Is a chainsaw a good thing or a bad thing? If you're cutting down a stand of trees, it's a good thing. If you accidentally chop off your finger, it's a bad thing."

The head of the nation's central bank virtually told mortgage lenders to load their shelves with chainsaws a year and a half ago. Lenders heeded his call. Now Federal Reserve Chairman Alan Greenspan worries about an epidemic of severed fingers.

Speaking before the Credit Union National Association, on Feb. 23, 2004, Greenspan lamented that not enough people had taken out adjustable-rate mortgages, or ARMs, in previous years.

ARMs have lower rates than fixed-rate loans. The reason: With an ARM, the borrower risks higher payments if rates increase. With a fixed-rate mortgage, the lender risks getting stuck with a low-yield investment if rates rise.

Greenspan was a fan
About two-thirds of homeowners get fixed-rate mortgages, paying a higher rate so the deep-pocket lender takes the risk. In his speech in 2004, Greenspan complained that a lot of those borrowers wasted money by spurning ARMs.

"American consumers might benefit if lenders provided greater mortgage-product alternatives to the traditional fixed-rate mortgage," he said. "To the degree that households are driven by fears of payment shocks, but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."

Lenders were happy to hear Greenspan encouraging consumers to "manage their own interest-rate risks." Mortgage companies began offering innovative ARMs, that previously had been pitched to the rich, to ordinary people . That includes option ARMs -- adjustable-rate mortgages that let borrowers choose how much to pay each month.

Four choices with option ARMs
Typically, consumers have four options each month:

The biggest payment is on a 15-year payoff schedule.
The next-biggest payment is on a 30-year payoff schedule.
Then there is an interest-only payment based on a 30-year payoff schedule.
The smallest payment doesn't necessarily cover all the interest accrued during the month. In this "negative amortization" option, the borrower owes more at the end of the month than at the beginning, even after making a payment.

These flexible loans are well-suited to homeowners who have irregular incomes, such as salespeople on commission or investment bankers who earn a nominal salary and get most of their income in an annual bonus. But option ARMs have spread beyond those types of borrowers. Hard numbers are difficult to come by, but option ARMs are much more popular now than they were 18 months ago.
 
 
In a widely cited report this spring, an analyst for UBS said more than half of borrowers who took out option ARMs in 2004 were making the minimum payments this year. Testifying to the Senate in July, Greenspan connected the dots, saying that the loans "are being used to enable people to purchase homes who would otherwise not have been able to do so." That's a bad reason to get one of these loans, he added.

When the Fed chairman made those remarks, none of the senators pointed out that, just 17 months earlier, Greenspan had encouraged homeowners to get ARMs and had chastised lenders for not offering enough alternatives to fixed-rate mortgages.

Risks vs. benefits
Lenders fume at Greenspan's backtrack and at the skeptical press that alternative mortgages have been getting lately. "As much as people want to vilify the mortgage industry, we're not idiots," says Walters. "Yes, there are risks -- but there are also benefits. Would you like to focus on the risks or focus on the benefits?"

The main benefit of the option ARM is its flexibility, allowing the borrower to make tiny payments when money is tight. Sophisticated borrowers can make minimum payments and invest the rest. And, as Greenspan noted, some borrowers use the loans to buy homes that they otherwise couldn't afford.

Option ARMs carry two primary perils. First, they allow people to sink a minimal amount of money in property that is expected to grow in value, resulting in a great return on investment. "But," Fed Governor Mark Olson said in a speech in June, "to the extent that these new mortgage products promote home-buying decisions that are premised on unrealistic rates of home appreciation, they raise concerns."

Payment shock
The other major risk of an option ARM comes from payment shock. Under certain conditions, the minimum monthly payment could more than double from one month to the next. Fitch Ratings established a pessimistic scenario in which the minimum payment on a $500,000 loan jumps from $2,148 one month to $5,548 the next. Such an outcome is unlikely, but possible if someone makes only minimum payments for five years while rates rise.

"There are risks, but they're far less dramatic than the hype of recent months," says Doug Duncan, chief economist for the Mortgage Bankers Association. "Innovative mortgage products have allowed a lot of consumers to become homeowners. However, borrowers need to realize that they're increasing their risk exposure with some types of products."

The Mortgage Bankers Association just released its own study of what it calls "innovative mortgage products." The 30-page report acknowledges that option-ARM borrowers might default more often but says lenders are giving homeowners what they want. "Borrowers need to be vigilant to be sure that they are prudently managing the incremental risk that these innovative new products represent," the report says.

There's that word again: risk.

Details on how the Option ARM Works