Beware the Option ARM Loan!

An Option ARM is an adjustable rate mortgage that gives borrowers options each month on how they want to make their payments.

The first option is to make the entire payment.

The second choice is to make an interest-only payment, which pays the interest that accrues during the month but pays nothing towards reducing the loan amount.

The third choice is to make what is the “minimum payment.” This payment is less than the interest only payment.

This option calculates the "minimum payment" based on the first month’s interest rate. Most of the time that rate is a very low “teaser” rate (around 1-2%.) However, as time goes on, anywhere from one month to five years into the loan, that rate is adjusted to a realistic interest rate.

Unfortunately, most borrowers (about 80% of them, based on Fitch Ratings) with an option ARM decide to pay the minimum payment each month - and that causes problems. If borrowers pay the minimum payment month after month they are getting more and more in the red, and not paying what is actually due on the loan. The interest that isn't getting paid is being added to the loan balance.

Once the loan balance grows to a certain point, the lender can demand that the borrower pay the full principal and interest, which the borrower isn't used to having to pay, on a loan that is now larger than it was initially. In this situation, the borrower ends up in a negative amortization situation, owing more than what originally was borrowed.

With the Option ARM, many borrowers get a false sense of security by making a minimum payment each month. Actually, their loan balance is growing and will have to be paid at some point and they're heading to an upside down position.

Make sure you understand what type of loan you're getting BEFORE signing the papers.

See this article on ways to prevent identity theft: Protect Your Identity