On the old-fashion versions your paymnet typically includes the principle and interest and both move up or down with the market. On the option ARMS there are a variety of versions that include interest-only, payments less than the interest owed etc. All of which substantially compounds negative amortization over a short period of time and leads to recasting if/when the loan reaches 115% to 125% of the original amount. Here are two different sources:
Like the name implies, option ARMS allow borrowers to choose from four payment options each time they write a check for the monthly payment. These payment options range from a payment at a fixed dollar amount that is less than the interest owed each month, to larger payments that include principal and interest.Each month, a borrower with an option ARM receives a monthly statement that lists four payment options from which they can choose. The following is an example of the four payment options offered to borrowers each month under an option ARM based on a $200,000 loan at current rates:
· “Minimum Payment” = $734 per month: This payment is initially set as a fixed dollar payment that is based on paying only interest at the artificially low introductory rate that is offered during the first 12 months. No principal is ever included in this payment. If the borrower continues to make the minimum payment, which is not enough to pay the interest on the loan, the unpaid interest is added back on top of the loan balance. When this happens, it’s called negative amortization.
· “Interest Only Payment” = $812 per month: This payment includes all of the interest due at the current interest rate, but no principal is included. As interest rates rise, this payment will increase. But since no principal is included, if the borrower only makes this payment, there is no principal reduction on the mortgage.
· “30-Year Payment” = $1,058: This payment is calculated to include interest (at the prior month rate) and principal in an amount to pay off the loan over 30 years. Unlike a fixed rate loan, this payment will increase as the adjustable interest rate rises. Borrowers who choose this payment option will have a higher payment versus the first two options, but they will also pay off their loan over 30 years, like it was done in the “olden days”.
· “15-Year Payment” = $1,568: Like the 30-Year Payment option, this payment is calculated to include interest (at the prior month’s rate) and principal in an amount to pay off the loan over 15 years, and the payment will increase as the adjustable interest rate rises. This requires a payment that is the largest of all options, but those that make these payments will pay the least in total interest costs and pay off their loan over 15 years.
One might take the view that all this flexibility in the hands of homeowners would be a good thing. After all, as long as option ARM borrowers made good financial decisions, such as making a few minimum payments on an option ARM and using the cash flow savings to pay down other high-rate credit card debt, how harmful can this be?
Unfortunately, the data on the use of option ARMS suggests otherwise. According to UBS, in the first quarter of 2005, 70 percent of option ARM borrowers made minimum payments, which means that they added more debt back to their loans. And according to Economy.com, a fast-growing segment of buyers taking out these aggressive loans is made of lower income families living in areas where home prices are expensive. Paying only the minimum payment is similar to making minimum payments on credit card debt: something all consumers are taught is a financial no-no.
The big risk to borrowers who make only minimum payments under option ARMs is the risk is that the mortgage will always increase. The minimum payment can also increase, or be “recast” when the mortgage increases to 115 to 125 percent of the original loan amount.
