Option Mortgage: What, How and Is it for You?
By Sadiya Anjum
Option Mortgage is a fairly recent development in the mortgage industry but it has become a highly popular loan despite the criticism it has endured. The rapid growth of the real estate industry has got property prices soaring. People are looking to buy bigger houses than what they can actually afford and the mortgage industry is more than happy to indulge their whims and fancies. The Option Mortgage has played a major role in this.
The Option Mortgage is attached to the Adjustable Rate Mortgage. The term ‘option’ aptly describes the nature of this particular mortgage. Essentially a payment option ARM mortgage is where the repayment options are in the hands of the borrower. Typically he is provided with 4 different payment options each month. The options are as follows:
- Thirty Year Repayment Schedule: This monthly payment includes both the principal and the interest. Payment is based on a 30 year amortization schedule.
- Fifteen Year Repayment Schedule: This option is the same as above except it is based on a 15 year amortization schedule.
- Interest only payment: The monthly payment will include just the interest on the outstanding principal. There is no reduction of the loan balance.
- Minimum payment: Also known as the partial interest payment. A minimum amount is set which is usually calculated on the first month’s interest rate. This minimum amount will not even cover the interest for that payment. So the unpaid amount is added to the loan balance. In short, negative amortization occurs.
The borrower is allowed to pick any of these options when making a payment each month. Making your payments responsibly could see you through this mortgage safely. But if only minimum payments are made and the value of the property does not increase, due to negative amortization the loan may far exceed the value of the property. At this point, the lender may choose to pull back his loan resulting in foreclosure.
The strength of this mortgage lies in its introductory rates. These are often so low that it gives people the capacity to obtain properties that they may have never dreamed of owning. Of course what needs to be remembered is that the initial rates offered are just teaser rates. Soon the borrower will be forced to make large monthly payments if he wants to keep his home.
Since the interest rates are attached to an index there is no saying how high they will rise. Plus if a minimum payment is made then the unpaid amount which includes the remaining interest is added to the loan balance. So a borrower may land up paying interest on the unpaid interest later!
Despite the several risks involved people are still opting for this mortgage. The purchase power offered in the beginning is too tempting. Also it allows the freedom to make payments at the borrower’s convenience. So if at any point during the loan period there is a cash-flow problem, the borrower can easily just make the minimum payment.
But to cut a long story short, this loan is too risky for a long term plan. This is best suited for investors flipping properties or those who intend to sell their home soon. For everyone else, this kind of loan may coax you into buying a house that you cannot actually afford. It may also tempt you to keep delaying a fully indexed payment to the next month or the month after that. And before you realize it, it leaves you bankrupt or homeless or both.
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