Pros and Cons of an Option Arm Loan, Pick a Payment, Pay Option, Freedom Loan or whatever the lender tries to call it. They are all the same type of loan, with some differences of course. I will explain to you the pros and the cons.
Ready? Here we go. Below are the components to the option arm / pick a payment loan. Take a look and don't worry if you don't fully understand everything. Following the explanation I will give you some examples of the pros and the cons.

Index: The most common index used is the MTA.
Here is the description: "The 12-Month Treasury Average Index (12-MTA) is based on the average annual yields on U.S. Treasury Securities adjusted to a constant maturity of one year, as made available by the Federal Reserve. The 12 months average is determined by adding together the annual yields for the most recently available 12 months and dividing by 12."
Confused? Don't sweat it. This is what it means: Monthly Adjustable, yes, monthly adjustable.


Margin: This is the biggie as it sets your effective rate (the real interest rate).
Here is the description: "The number of percentage points (for example, 3.5) the lender adds to the index rate to calculate the ARM interest rate at each adjustment. The margin is set in the mortgage contract, remains fixed for the term of the loan and is not impacted by the financial markets and movement of interest rates."
Okay here is what you need to know. Index plus margin is your true interest rate. So for example, the MTA right now is at 4.14* and if your margin is at 3.5 then your effective interest rate is 7.64!
(Loan officers will try to make you believe your interest rate is 1%) *June 06

Effective Rate: As you have read, effective rate(real interest rate) is index plus margin the only difference would be in the type of index the loan officer is pitching to you. There are other indexes (or indices as the smart people would call them) such as the COFI, COSI, LIBOR and of course MTA. Let's not worry about the differences right now, the important fact to know is how your effective rate is computed. Now you know, right?

Payment Options: Typically you will see four payment options after the first month. The minimum payment, the interest payment and a 15 year and 30 year amortized payment.

Minimum Payment: Ahh, the minimum payment. This is the payment based on the start rate, normally 1% although lenders are beginning to push up the start rate a little bit. Here is what you need to know: The minimum payment does not cover the interest payment due on the loan. Did you guess negative amortization? If you did you are right!

Interest Only: When you make the interest payment you will not have any negative amortization. You will not pay down the principal but you will not add to it. So, here is what you need to know about this: The difference between your minimum payment and the interest payment is your negative amortization. Yes, if you make the minimum payment the difference is what is added to your loan balance. Lenders like to call it "deferred interest" on the statement. I guess they think it will not be noticed. What would the borrower think if they put "negative amortization" on the statement? You got it.

Amortized Payments: This is a payment based on repayment of principal and interest. No negative amortization on amortized payments, your balance actually goes down.
Yearly Increase: This one is pretty simple. Your minimum monthly payment will increase 7.5% after each 12 months and remain constant for the following 12 months until the next adjustment period. So, your payment goes up once per year. So, if your payment (excluding taxes and insurance) is $800 per month your yearly increase would be $60.

Loan Term: The most common is for 5 years although there are some that extend up to 10 years.

Negative Amortization: By now you should know what this is but in case you forgot here it is again. Negative amortization occurs when you make the minimum payment. The amount of negative amortization is the difference between your minimum payment and the intereste only payment. This amount is added to your loan balance. Lenders show this on your statement as "deferred interest".

Prepayment Penalty: This type of loan typically has a 3 year prepayment penalty although you can find them with 1 year and in some cases without a prepayment penalty. Loan officers usually do not disclose these options.

Payment Cap: Normally the option arm has a 9.95% payment can although some have a 11.95% payment cap. Basically this means that the effective interest (real interest rate) rate can go up to those caps. You remember the effective interest rate don't you? Very rare for this to occur because of the following component to an option arm.

Recast Clause: Okay now you are reading insider secrets so pay close attention to this: The recast clause says that if your loan balance goes up to a certain amount over your original loan amount that the loan can recast to a fully indexed rate. What this means is that potentially you can be going along with your option arm happily making your minimum payments and then you receive a notice saying your loan has recast and your minimum payment is not your minimum payment anymore - it is now the fully indexed rate payment! The payment can go up dramatically!
Usually the recast amount is 110% of the original loan amount although some lenders offer a higher recast amount. No loan officer will ever tell you or make you aware of this recast clause.