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December 2004
Index of all
past
Affiliate Corner columns
Is the Option A.R.M. an option?
By Jody Klouser, CML
Pulte Mortgage, LLC
 In more recent months
with interest rates increasing, mortgage specialists have seen an increase in inquiries for those interest rates
advertised at 1.99 percent to 3.99 percent; at the same time, buyers wonder why those specialists are quoting
higher rates on a 30 year fixed. Even some REALTORS® call to ask about these low advertised rates. What the
general public doesn't understand is what type of loan is truly being advertised with these low interest rates.
There are various names for these low interest rate loan programs; however they all boil down to the same thing - negative amortization.
How Negative Amortization Works
Let me go on record as saying that I think this is a very good loan for some people. The problem I do have with it is that
most mortgage professionals do not know how to explain it well. Therefore, they put the consumer in the very
difficult position of not understanding what is clearly the most complicated loan in our industry.
The reason this loan is so complicated is that it provides so many different monthly payment
options. It puts consumers in a position in which they literally make a different payment decision
each month. It is this complicated formula, this decision they have to make each month, that is
the beauty of the loan if people understand their options.
This loan provides significant flexibility and the ability to use the 1st Trust Deed as an
equity line of credit. The ability to make a negatively amortized payment puts people in a
position in which they can literally tap into the equity of their home on a monthly basis
if they choose to do so. People who are in a cyclical type of business, such as accountants
or sales people, can use this loan effectively to make lower monthly payments when they have
less income, and make up that difference at another time of the year when their income is at
a higher level. The following script is one that I use to explain how a negative amortization adjustable works.
Explain that this adjustable is stable, and provides significant payment options. "Mr.
Jones, the 11th District Cost of Funds adjustable is very unique for several reasons. First,
let me state that the index itself, the 11th District Cost of Funds is by far the most stable
index in the industry. It is this stability that makes this adjustable very attractive.
"However, this loan provides you with several different payment options each month. Without
knowing what those payment options represent, you can put yourself in a problematic situation.
Therefore, I want to make sure I educate you on exactly how this adjustable works. If you choose
to select this as your loan program, you need to fully understand what your options are each month.
"Let's establish that the 11th District Cost of Funds adjustable is no way different than
any other adjustable in that it has a fixed margin, a varying index, (which in this case is the
11th District Cost of Funds), and caps.
"You will start off at an introductory teaser rate of 3.95 percent for the first month. At
the end of the first month, the lender will take that fixed margin and add it to your varying index
to determine your new interest rate. The distinction between the 11th District Cost of Funds adjustable
and any other negative amortization adjustable is that your payment remains the same for one year.
However, your interest rate changes each month.
"I know that sounds like a contradiction, Mr. Jones, but it really is not, because on an 11th
District Cost of Funds adjustable, you are given a minimum payment option.
"Let me give you a specific example to allow these numbers to sink in. Your payment coupon comes
in the mail and you are given three options:
- Option #1: Make the payment based on the teaser interest rate of 3.95 percent.
- Option #2: Make an interest-only payment based on the fully-indexed interest rate of six percent.
- Option #3: Make a fully amortized payment based on a 30-year amortization schedule at a
fully-indexed rate of six percent."
"Mr. Jones, the term, "fully-indexed rate" means the total of the margin plus the
index. For instance, let's say today the value of the 11th District Cost of Funds Index is 3.25 percent.
"We've determined that the index is the changing variable in this equation. Let's say you've
been given a fixed margin of 2.75 percent. Each and every month, the lender will take the fixed
margin and add it to the varying index to calculate the interest rate. Therefore, the sum of the
fixed margin (2.75 percent) and varying index (3.25 percent) would equal six percent."
"This is what that means to you:
- Option #1: A payment of 3.95 percent can be made on a monthly basis for the first year of the life
of the loan. On a $200,000 mortgage loan, this comes to $949.07 per month.
- Option #2: Pay an interest-only payment of 6 percent. On a $200,000 loan, this comes to $1,000 per month."
"The difference between Option #1, the negatively amortized payment of $949 per month,
and Option #2, the interest-only payment of $1,000 per month, is $50.93.
"If you continue to pay at the 3.95 percent teaser rate from Option #1, you will be short
$50.93 per month on the amount of interest that you owe on the loan. This is what negative amortization
is all about. This $50.93 a month will be tacked on to your principal balance, and you will be making
payments that don't completely cover the amount of interest that is owed on a monthly basis.
"This is where people can get into trouble, and you begin to hear the horror stories
about people who didn't understand the concept of negative amortization on their payments.
Before they knew it, they woke up and found they owed more money on their house than what it was worth.
"I'm here to tell you that it doesn't have to be that way. This loan program can work to
your advantage if you use it correctly, because it allows you to control your monthly payment
based on your cash flow.
"Once again, Option #1 is a payment at 3.95 percent, negatively amortized; Option #2 is a
payment at six percent, fully-indexed, and with a payment of $1,000 per month, and you're
treading water. Let's move on.
- Option #3: Pay the fully amortized, fully-indexed payment at six percent. On your $200,000
loan, this payment would be $1,199 a month.
"These are your three options, Mr. Jones, and you'll have each of these three options every
single month when you make your payment. You are free to choose, as each month goes by, any one of
these three options."
As you can see, a negative amortizing loan can be a very useful loan if explained completely and
the borrowers are disciplined and educated enough to understand the full impact and management needs of this loan. |
