Option Arm Loans and Negative Amortization : What are They all about ?

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However, sophisticated borrowers who understand the power and nuances of the Option ARM can take advantage of the brilliant mortgage alternative. Even though most major financing institutions no long offer Option ARM loans, older ones already in existence prevail.

They’ve gotten a bad reputation in the mortgage loan industry because Option ARMs contain a negative amortization (also known as “neg am”) feature that sounds harmful by its wording.

But “neg am” is a misunderstood term that actually allows a borrower to tap into their equity, whichisn’t much different than availing oneself of an equity line of credit if use smartly. It can be a wise loan choice for people who don’t have steady, predictable salaries – but fluctuating incomes from month to month that make it hard to predict how much money to budget for bills.

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Option Arm Loans and Negative Amortization

THE BASIC ADVANTAGES OF OPTION ARM LOANS

Based on cash flow and other factors, borrowers who took Option ARM loans were allowed to choosefrom three payment options monthly: minimum, interest only or fully indexed.
What Exactly is Negative Amortization?

The situation called negative amortization occurs when a monthly payment doesn’t include the complete amount of interest that’s due. In that case, the unpaid interest amount is then added to the principal balance that’s due. Option ARM loans grant the borrower the ability pay a minimum monthly payment, which is less than full interest. Normal amortizedpayments reduce your balance, while interest-only payments are directed towards interest alone so they cause your principal balance to remain the same. A negative amortization payment, however, increases your loan balance.

The next examples are based on a $200,000 loan, and the difference between a minimum payment and a fully indexed payment is $250.

THE BASIC COMPONENTS OF AN OPTION ARM

The Start Rate

Usually a low teaser interest rate, the start rate usually only lasts from one to three months. It represents the rate on which your minimum monthly payment is calculated.

Minimum Options Payment

The minimum options payment is generally fixed for a minimum of one to five years. The amount is less than a full interest payment. For instance, a $200,000 loanwith3.95% start rate would enjoy a minimum option payment of $949.07 per month.

Interest-Only Option Payment

As the name implies, this type of payment is only paid towards the interest due, and not the principal balance. For a $200,000 loan with a 6% interest rate, the payment would be $1,000 monthly, and the interest rate would adjust each month.

Fully Indexed Option Payment

If you add the index rate to the margin, you’ll get the fully indexed interest rate. This also adjusts monthly. A 6% fully indexed option payment on a $200,000 loan would equal$1,199 per month.

Index Rate

A good way to examine the index rate is to view it as the rock-bottom minimum return on an investment. The rate is published each month, and it is based on various averaged returns.

The four basic indexes are the Monthly Treasury Average, the 11th District Cost of Funds, the London InterBank Offered Rate or LIBOR and the Cost of Savings Index, also known as COSI.

Margin

The margin is the profit that the lender makes, and it is fixed for the loan’s life and expressed as percentage points. A typical margin rate might equal 2.75%.

A lender might request the same average return rate that T-bill investors receive – and if that average rate is 4.00% — the lender may choose to add a fixed percentage rate of profit over and above the average rate. In that case, the lender could add 2.75% to the 4.00% Monthly Treasury Rate and earn a 6.75% fully indexed rate.

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The Payment Cap

The payment cap is the maximum amount that a payment is allowed to increase. It is a specific percent that’s added onto the minimum payment, such as 7.5%, for instance. If the minimum payment equals $949.07 with that payment cap percentage, the next year it cannot exceed $1020.25 per month.

That’s because 7.5% of $949.07 equals $71.18, and when you add $949.07 plus $71.18, the sum is $1,020.25. This does not address a recasting situation.

The Lifetime Cap

The lifetime cap is the maximum interest rate you will ever pay and is shown as a percentage. A typical start rate might be 3.95%, while a lifetime cap could be 9.95%.

The Lifetime Floor Rate

The lifetime floor rate is just like it sounds: a rate that’s the bottom floor rate that won’t ever decrease below the margin rate.This means that your individual interest rate won’t ever fall below the margin.

The Negative Amortization Cap

Making minimum payments each month dictates that the difference between your full interest payment and the payment you have made will be added onto your loan balance, but that total balance can’t balloon to amounts that exceed 110% to 125% of your original principal balance.

Recasting

A lot of Option ARM loans necessitate that they be recalculated or re-amortization every five years. Since there are 60 months in a period of five years, the 61st payment – or directly prior to that payment – will be the time when your unpaid interest will be added onto the loan and recalculated.

If you are one of the folks who havepaid large sums of money toward your principal balance, this recasting should reward you with lower payments in the future.

Overall, Option ARM loans have a variety of twists and combination hybrids with lots of terms. If it becomes available again as an option with the major lending institutions, make sure you fully understand all the nuances of this loan type before diving into one headfirst.

Tag : arm loans , arm loan , what is an arm loan , arm loan rates

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Option Arm Loans and Negative Amortization : What are They all about ?
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