“I want the low payments that are available on an option ARM, but I don’t know what I should be looking for in shopping for one. Can you help?”

Reluctantly, I don’t much like the option ARM because of its complexity and hidden booby traps. However, some borrowers will ignore all warnings because they are mesmerized by the low initial monthly payment, calculated at rates as low as 1 percent. If you are going to take an option ARM anyway, knowing their major features may save you some grief. Here they are, in order of importance.

Margin: The option ARM adjusts the rate monthly. That means that the lovely looking 1 percent rate you saw in the ads holds for just one month. In month 2 and every subsequent month, the rate is set to equal the most recent value of the rate index plus a margin.

For example, assume your ARM uses MTA as the index and your margin is 3 percent. In May 2005, MTA was 2.633 percent. If your first month with this loan was May, in June your rate would jump from 1 percent to 5.633 percent.

The margin is fixed for the life of any one loan, but it varies widely between borrowers. This makes it feature number one on your shopping list. Further, if you don’t shop the margin, the chances are good you won’t even know what it is until the loan closes. Loan providers usually don’t volunteer it, and it is not a required disclosure.

Maximum Rate: There are no rate adjustment caps on an option ARM. The only limit set on the rate is a maximum over the life of the contract. This makes the maximum rate feature number two on your shopping list. In today’s market, look for a maximum of about 10 percent, but it can vary some from lender to lender. 

The tradeoff between margin and maximum rate is a judgment call, but I would put it at about 2.5 to 1. If lender A offers a 3 percent margin and 10 percent maximum, for example, and lender B wants a 4 percent margin, I would look for a 7.5 percent maximum from B to make the deals roughly equivalent.

Index: Most option ARMs use one of 4 indexes selected because of their relative stability. These are called MTA, COFI, CODI and COSI.

There isn’t a lot of difference between these indexes. Over the last 12 years, COFI and COSI have averaged 4 percent while MTA and CODI have averaged 4.2 percent. (These figures come from www.mortgage-x.com, which is an excellent source of information on ARM indexes). Hence, in comparing different option ARMs, you can add .2 percent to the margin on an MTA or CODI ARM to make them comparable to a COFI or COSI ARM.

Recast Period, Negative Amortization Cap, and Payment Shock: The great appeal of the option ARM is the low initial payment combined with the 7.5 percent cap on annual payment increases. The payment in the early years is not affected by interest rate changes, and in most cases does not cover the interest. The result is a rising balance, or “negative amortization.”

However, a day of reckoning must come. Sooner or later, the payment must become fully amortizing – large enough to pay off the balance over the remaining term. This can happen smoothly by successive 7.5 percent annual payment increases, or suddenly when the loan reaches the recast month or hits a negative amortization cap.

On most option ARMs, the payment is recast every 5 years, though some recast every 10 years. On the recast date, the payment becomes fully amortizing, no matter how large an increase that may require.

Option ARMs also have a limit on how large negative amortization can go, ranging from 110 percent to 125 percent of the original loan amount. When the balance hits the cap, the payment is immediately raised to the fully amortizing level, no matter how large an increase that may require.

All other things the same, a longer recast period and higher negative amortization cap will delay a payment shock, and the shock will be somewhat smaller when it occurs. For example, in one of many tests I ran that are reported on my Web site, the payment on an ARM with 5-year recast rose by 7.5 percent for 4 years, and by 88 percent at recast. The same loan with a 10-year recast rose by 7.5 percent for 9 years, and then by 61 percent.

The bottom line is that a longer recast and higher negative amortization cap are desirable, but I would not accept a larger margin or higher maximum rate to get them.

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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