Option Arms Right for You

These popular adjustable-rate mortgages offer flexibility, but they come with a host of risks.
Jackie Crosby, Star Tribune

In April, Marie Senn found the home of her dreams, a condo that hadn't even gone on the market yet. Then she fell into a nightmare of a mortgage -- a type of adjustable-rate mortgage known as an option ARM.

"I was a young buyer," said Senn, 24, who said she wasn't told that she could qualify for low-interest loans targeted at first-time homeowners.

"I'd never heard of this loan," she said. "There are so many things that I wish I knew then."

Option ARMs are one of the riskiest, most complex loan tools available, say a growing number of mortgage brokers. They allow borrowers a range of options, from making a big principal payment when they're flush with cash to paying a minimum amount that could be lower than even the interest on the loan.

"If I was in charge of the world, they wouldn't exist." said Kris Wilson, a loan officer with Summit Mortgage in Bloomington. Wilson said she has seen a growing number of lenders put people like Senn into option ARMs by enticing them with the possibility of extremely low payments. What they don't explain, Wilson said, is that by making these low payments, borrowers will get socked with an unexpected payment shock when the loan
gets "recast" or recalculated.

"It sounds like the streets are paved with gold," Wilson said. "But people don't realize how big a trouble they can get into, and then they quickly end up upside down."

That's where Senn was headed. Her payments eventually would have tripled from a low payment that came with her option ARM if she hadn't just refinanced into a fixed-rate mortgage, which still leaves her strapped with higher monthly payments than she had planned.

"I want to put this behind me," she said.

Here's what you need to know:

WHAT IS AN OPTION ARM?

Option ARMS right for you? Option ARMs hit the financial scene in the mid-1980s, when fixed mortgage rates were soaring into the low double digits. Option ARMs typically offer four monthly payment options. They range from fully amortized principal and interest payments to interest-only payments to "minimum" payments that may not even cov er the full amount of interest you're being charged every month.

"Consumers should really be careful to understand that affordability shouldn't just be gauged by the introductory or first-year rate," said Eric Ewald, managing director of the Minnesota Mortgage Association. "They should look down the line two, three or four years and talk with their lender about the worst-case scenario."

THE UPSIDES:

Homeowners can make low payments when money is tight and pay more when they can afford it. The other selling point -- an extremely low minimum payment for the first year -- is also its biggest risk factor.

Homeowners could pay as little as 1 or 2 percent, with payments that increase as much as 7.5 percent per year. Another upside for a narrow group of homeowners is the option to make interest-only payments. Mortgage brokers say this can be a good strategy for those who plan to be in their homes for a short period, say five to seven years, or whose income might be going up in the near future.

THE DOWNSIDES:
Payment shock when the interest rate on your adjustable rate mortgage increases, which can double or triple the initial payment. Because the initial payment is so low, borrowers are tempted to purchase more home than they ultimately can afford.

If you pay only the minimum amount, which may not cover the interest on the loan, you can wind up in a state of "negative amortization" with unpaid principal and interest gets added to the balance of the loan, leaving you with a house that's worth less than your mortgage. Every five or 10 years (or sooner if you hit a negative amortization maximum) the bank will "recast" your loan so that it can be paid off within the remaining term either at the current interest rate or a rate spelled out in your loan agreement.

RIGHT FOR YOU?
An option ARM can work for people who are not living from paycheck to paycheck.

It can work for families whose incomes are likely to get a significant boost in the future, such as a medical student who's about to get a full-time job or a stay-at-home parent who soon will return to the work force.

Consider it if you have an irregular income, say you're a salesperson on commission, or you work in a field with a low monthly salary but a high year-end
bonus.

"There are risks with a loan like this, but it's still a good product," said Ewald, of the Minnesota Mortgage Association. "In an ideal world, you've got wonderfully educated consumers working with caring loan officers."

IN TROUBLE?

The Minnesota Housing Finance Agency: www.minnesotahousing.com
Homeownership Preservation Foundation: www.hpfonline.org
Lenders Who Care: www.lenderswhocare.org
Don't Borrow Trouble: www.dontborrowtroublemn.org
Home Ownership Center: www.hocmn.org

JACKIE CROSBY • 651-298-1541
Jackie Crosby • jcrosby@startribune.com