Pay option ARM

Homeowners and investors planning on owning a home for a short time and borrowers looking for a more flexible monthly payment schedule might consider the option adjustable rate mortgage (ARM). The combination of reduced start and qualifying rates and low initial mortgage payments allows owners to borrow more money ‑‑ or qualify for a larger home, in some cases ‑‑ and is making pay option ARMs increasingly popular with shoppers.

However, when shopping for an option ARM, make sure you understand the facts. For instance, the initial interest or start rate is only a “teaser” that applies to a specific timeframe ‑‑ one month, for example. So discuss this with your lender. And carefully review the margin and the fully indexed rate (FIR) in combination. The margin is the number of permanent percentage points or “markup” added to the index rate by the lender to calculate the interest rate of an ARM for the length of the loan. The FIR is based upon the margin and index of the loan, a reference point based on various financial indexes use by lenders to estimate their cost to loan money.

Understanding which index the lender is using and look at historical data about how that index has been impacted by market conditions in recent years to gain insight into how the lender’s ARM will perform. An index that adjusts quickly each month, for example, would be good if rates are decreasing. But a borrower would want a slower index if rates were rising. Either way, the index will change throughout the life of the loan, so understand how the margin and the FIR will look together. If the current index rate is 5 percent with a 2.5 percent margin, for instance, the FIR would be 7.5 percent. In addition, ask about rate caps, which limit the percentage a rate can increase over the life of the loan, and get loan fees on paper.

Borrowers should do their homework and compare loans. But if flexible pay option ARM seems right for your loan needs, great. It has some wonderful benefits.

Unlike fixed rates mortgages that remain static for the life of a loan, the pay option ARM provides the borrower with complete flexibility by allowing owners to select a variety of payment options each month.

The first is the minimum payment option. This can reduce your overall monthly expenses. However, if this option doesn’t cover the monthly interest due on the loan, be aware. The shorted amount is added to the loan, and the loan balance will rise.

Still, a borrower could defer interest by selecting an interest-only payment that would be less than the regular minimum due each month. Keep in mind, however, that an interest-only payment does not reduce the loan’s principle. A traditional monthly payment option allows borrowers to make equal payments based on a fully amortized schedule, which gradually eliminates both principal and interest, based on a 30-year loan. Or a borrower could build equity quickly and cut more than 50 percent of their interest costs by paying the loan over an accelerated 15-year period.

Another option allows the borrower to reduce the life of the loan and decrease future mortgage bills by making additional principle payments.

Whatever option is right for you, just think carefully.