Have you seen the ads everywhere for "1% Mortgage Loans" - offers that show how you can chop you monthly payment in half?
These are Option ARM (adjustable rate mortgage) loans. They usually offer a low start rate – 1%, 1.5%, 1.95%, 2%, etc.
This type of loan has become very popular recently, particularly in places with high and escalating real estate values where the loan can allow people to buy or keep expensive properties.
Basics
The Option ARM loan is a loan that has to be understood first because it can be good or bad, depending on your circumstances and goals.
The Option ARM mortgage rate is usually an introductory rate (the APR or annual percentage rate is usually much higher).
The initial interest rate may only be for the first month.
The appeal of this type of loan is that it typically allows you to make a choice each month about how much you want to pay for your mortgage. That’s what makes it different than a regular mortgage bill: you have an OPTION to choose which payment you want to make.
These choices each month are usually a minimum payment (usually less than the interest-only level), an interest-only level, a 15 year amortization level, or a 30 year amortization.
Example
A 1% minimum option loan at $400,000 with a 30 year loan term can have four different payment levels:
the minimum payment of $1,287
an interest-only payment of $1,649
a 30 year payment of $2,134
or a 15 year payment of $3,152.
When you get your bill, you can decide that month how much you pay.
The Catch
Here is the first catch: when you make the minimum payment, any amount short of the interest-only payment is added onto the principal of the loan. If the interest-only payment is $1,500 per month and you only pay $1,200 per month minimum payment, then you are increasing the size of your loan by $300 ($1,500 less $1,200). An increase in your loan size is known as “negative amortization”.
If you continue to make minimum payments over time, your loan balance will continue to increase.
The level of your minimum payment can also be reset, typically on an annual basis. The minimum payment is usually fixed for 12 month periods at a time. Once a year, the minimum payment goes up slightly. For example, the minimum payment each month for the first year may be $1,200, then the second year it may be $1,300, the third year it may rise to $1,400, etc. Because of this escalating feature, some people refinance again after around 3 years so they can go back to the lower minimum payments.
Minimum payment levels usually last for the first 5 years of a loan, after which the loan reverts back to a regular adjustable loan.
There can also be a reset of the loan if the loan size increases too much relative to the value of the property.
For some people a minimum payment may be the option they choose once in a while, such as around the holidays.
Interest Rate on Loan
What is the interest rate on this type of loan? Usually it adjusts on a monthly basis and is the sum of an interest rate index plus the “margin” which is the bank’s profits. The interest rate index can be based on different published indexes, such as the LIBOR, COSI, or CODI index.
For example, your interest rate may be:
3.2% interest rate value for your index
Plus 3% lender margin
=Total 6.2% for that month
Some of these indexes change value faster than others. These loans also usually come with a lifetime cap on the interest rate, so the upside interest rate risk is clearly defined.
The Risk
If your loan continues to increase, and the value of your property drops, then you can end up owing more on the property than the house is worth.
The Potential Uses
If you have lots of equity in your property and don't mind your loan size going up, consider this loan. Often times, people have found that gains in property values are higher than the increase in their loan size. For example, a customer may start the year with a loan of $300,000 on a $400,000 property and may end the year with a $310,000 loan on a $450,000 property. The borrower’s equity in the home has still increased, despite the increase in loan amount. Of course, this is equity on paper.
The 1% loan often only goes up to the first 80% of the value of the property, after which if an additional loan is necessary it is usually an equity line at a higher rate. Borrowers will still use this loan because the combined expense is still lower than other options.
Qualifications
This type of loan can be done with both full documentation and stated documentation borrowers. This can depend on other factors, such as:
Credit
Level of equity in the property
Borrower loan history
Because of the potential for negative amortization (where the loan size increases rather than decreases), banks usually wanted to see some equity in the loan before making it. This was usually at least 10% equity in the loan (for example, a $450,000 loan on a $500,000 property has 10% equity). This 10% equity gave the lender some “cushion” if the loan value went up and the property declined in value.
There are now lenders that will do this with only 5% equity, and in some cases on equity. These loans can be structured in two parts: the first 80% as a minimum option payment loan, and the final 15% or 20% as a second loan with much higher rates.
Rental Properties
For rental properties, a minimum payment may allow you to collect enough rent to make a monthly profit or be closer to it. The size of the Option ARM loan relative to the value of a rental property is usually lower than for a primary residence.
For some borrowers the minimum payment may be an attractive option because it allows them to put the minimum cash into a property while riding up its value (this is the concept of leverage).
This article is from the http://www.archerpacific.com Loan Library.
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