Loan Amortization

This is a question that a good percentage of mortgage professionals don’t even know the answer to. The Option ARM has been the subject of much controversy and the source of much profit for loan officers. While it may appear complicated at first, the Option ARM is relatively easy to understand once properly dissected.

What is an Option ARM?

An Option ARM is a type of mortgage loan in which the borrower is typically given 4 payment options each month. In general, Option ARM’s are never fixed and begin adjusting from month one of your loan. The reason for the popularity of the Option ARM stems from the “minimum payment” option, which allows borrowers to make a payment in which they are not only not paying principal, but not even making the full interest payment on a loan.

What are the 4 Payment Options?

- 15 Yr Loan (highest payment)

- 30 Yr Loan

- Interest Only Payment

- Minimum / Negative Amortization Payment

What does each Payment Mean?

The 15 Yr Payment – This payment is amortized over 15 yrs. Since it pays your loan off in half the time of a 30 yr loan, it is going to yield the highest payment. Unlike a 15 yr fixed, this payment fluctuates on a month to month basis, and unless it is a hybrid option ARM, will begin adjusting from month one.

The 30 Yr Payment – This payment is amortized over 30 yrs and will be about 75% of the 15 yr payment. Like the 15 yr payment, this payment fluctuates on a month to month basis. Often times people are fooled into thinking that the 15 and 30 yr payments are fixed. When someone hears the word fifteen or thirty in regards to mortgage, they have a natural tendency to attach a “fixed” after them.

Interest Only – This payment, like the 15 and 30, also adjusts on a month to month basis. The interest only payment is just that, interest only, and by continuously selecting this payment each month, you will not pay down your mortgage. Since the bank would like its principal back at some point, they will only allow you to select this payment for the first few yrs of the loan if you are never selecting either of the amortized payments.

Minimum Payment – Since “minimum payment” sounds so much nicer than “negative amortization payment”, expect to hear it referred to as such. If you have seen loans advertised for 1%, or a $300,000 mortgage with a payment of only $600, the minimum payment is what they are referring to. The minimum payment is able to be so low (like $600/month on $300,000 loan) because you are not even making the full interest payment on the loan. In some cases you are not even making half the interest payment. So effectively you are continuing to borrow more and more money from the bank, and instead of paying down the principal, like a standard loan, you are actually adding to it. Like the Interest Only payment, if the minimum payment option is the only one you are choosing, the bank will eventually take it away. Not only will the bank remove this option, they will recast your loan at the new, now larger principal amount.

How Is Each Payment Calculated?

We will use the nice round number of $100,000 as an example. As stated above, the payments vary from month to month, so as the index rate changes so does your payment.

Like any type of ARM, you have a fixed margin that is established at the inception of the loan. Note that brokers can typically adjust the margin, the higher it is the more compensation they receive. So if you are in the market for an ARM or Option ARM, make sure to compare not just the initial rate, but the margin as well.

To calculate your interest rate on any type of ARM simply add your margin to the index that is attached. Margin + Index = Rate

Typical Option ARM Indexes:

COSI (Cost of savings Index)

CODI (Cost of Deposit Index)

MTA (Monthly Treasury Average)

COFI (Cost of Funds Index)

So let’s say, for this example, we are using the MTA, the Option ARM has a margin of 4% and the MTA is currently at 1.8% Your interest rate for all 3 of the 4 payments would be 5.8% (4% + 1.8%). One of the advantages to the option ARM is that as market declines so does your interest rate. Many options ARM’s now have rates in the 4′s and 5′s.

So on the $100,000 loan (note amounts do not include taxes, insurance, or PMI):

15 yr Payment @ 5.8% = $833 30 yr Payment @ 5.8% = $587 Interest Only @ 5.8% = $483 Minimum payment @1%= $321*

* Note that the minimum payment is calculated as a fully amortized payment and not an Interest Only payment

If the borrower were to choose the “Minimum payment” they would be adding to their principal the difference between the minimum payment and the interest only payment. In the above example the borrower is under-paying the interest by $162 ($483 – $321=$162).

By: David Wolbarst

About the Author: