“Can you explain flexible-payment ARMs, and their pros and cons?”

A flexible-payment ARM (FPARM) is an adjustable-rate mortgage that allows (but does not compel) borrowers to make very low initial mortgage payments that rise over time. The major drawback is that those who select the minimum payment option may suffer “payment shock” – a sudden and sharp increase in the payment for which they are not prepared.

FPARMs are also very complicated, which creates a danger that borrowers will take them without fully understanding the risks. Borrowers who don’t understand FPARMs, furthermore, may overpay, which increases the risk of payment shock.

The main selling point of FPARMs is the low payment in the early years. This allows borrowers to buy more costly houses, or use the monthly payment savings to pay down other high-cost debt, make home improvements, invest in the stock market, and on and on. Loan officers and mortgage brokers selling FPARMs have long lists of ways to use the cash flow savings. They may provide little information, however, about how FPARMs work and what the risks are.

The initial interest rate on a FPARM is a “teaser,” it can be as low as 1.25 percent, but it holds only for the first month. In the second month, the rate jumps to equal the “fully indexed rate”: the most recent value of the index used by the ARM, plus the margin.

Consider an FPARM that is past its first month, which uses COFI as its index and has a 2.75 percent margin. The rate on this FPARM in December 2003 would be the value of COFI in October, which was 1.909 percent, plus 2.75 percent, or 4.659 percent. Since the margin affects the rate in every month but the first, it is much more important to the borrower than the initial rate. With a higher margin, you also face a greater danger of future payment shock.

The interest rate on an FPARM adjusts monthly, with no limit on the size of interest rate changes except a maximum rate over the life of the loan. The maximums generally range from 9.95 percent to 12 percent or higher.

Two other features of FPARM contracts, however, soften the impact of changes in market rates on FPARM borrowers. One is that almost all Farms offer rate indexes that adjust slowly to market changes. COFI is one such slow-moving index; others are COSI, CODI and MTA.

The impact of rate changes on borrowers is also softened by a temporary disconnect between the interest rate and the monthly payment. While the rate adjusts monthly, the payment adjusts annually and, subject to the exceptions noted below, cannot increase by more than 7.5 percent a year.

The initial minimum payment is based on the interest rate in the first month. While the initial rate holds only for that month, the initial payment holds for the entire first year. It is also the base for new minimums calculated for each of the next four years. The minimum in the second year is 7.5 percent higher than the minimum in the first year; the minimum in the third year is 7.5 percent higher than the minimum in the second year, and so on through the fifth year.

The rule that the minimum payment rises by no more than 7.5 percent a year has two exceptions. The first is that every 5 years the payment must be “recast” to be fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the current interest rate – regardless of how large an increase in payment is required.

The second exception is that the loan balance cannot exceed a negative amortization maximum. After the first month, the minimum payment usually will not cover the interest due and the difference is added to the balance. All FPARMs have negative amortization maximums, which range from 110 percent to 125 percent of the original loan balance. If the balance hits the negative amortization maximum, the payment is immediately raised to the fully amortizing level.

In sum, FPARMs offer the promise of very low initial payments that under favorable conditions will not rise by more than 7.5 percent a year. The risk is that the recast requirements and negative amortization caps included in all FPARMs will trigger much larger payment increases. Next week I will assess how great the risk is, and what borrowers and lenders can do to make it manageable.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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