Can you imagine a world where everyone had to buy a house using only cash on hand? Very few people would own a home if the world were like that.
Lenders know this and have come up with a number of loan types (they call them products) that ostensibly help people get into their dream houses. Some of these products, however, carry more risk to you than others.
The most notorious of these loans is the option ARM, sometimes called a "pick a payment" mortgage and it is as dangerous as it is powerful.
Introducing the Option ARM
It's called that because the option lets you choose between three payments: (1) an obscenely low payment with a 1% interest rate, (2) a low interest-only, or no deferred-interest, payment, and (3) a standard principal and interest payment.
The ARM stands for "adjustable rate mortgage" where the interest rate is fixed for a certain period of time, say five years, and the adjusts based the on what the interest rate is at that time.
There are three potential traps in this type of exotic mortgage.
Trap 1: Low, Low Monthly Payment!!!
The first is the "obscenely low payment" option. When you use this option, you pay less than the interest you owe every month.
This difference is new debt added to the end of your loan, which you pay interest on. This is called negative amortization and it means you pay less that month but end up owning less of your house every time you use this option.
Trap 2: Don't Steal Our Profits
The second trap is the pre-payment penalty usually included in these loans. The pre-payment penalty is the fee you pay if you want to payoff your mortgage within a certain period.
The pre-payment penalty ensures lenders make a certain amount of money on the loan. Most often this penalty kicks in to keep you from refinancing the loan but sometimes this penalty is enforced when you go to sell your house.
Trap 3: Surprise! Your Monthly Payment Is Now...
The third trap is the rate reset. Because the interest rate on ARMs is only fixed for a certain period, the rate will eventually change to the prevailing rate, which may be much higher than the previously fixed rate.
Many unsophisticated borrowers don't negotiate a cap in the amount the rate can change and have recently been hit with large increases.
While this applies to both regular ARMs and option ARMs, the triple play of a large pre-payment penalty, negative amortization plus this costly rate reset makes it a perfect storm for financial disaster if you're not careful.
There is nothing inherently evil with this powerful tool if you know the dangers involved in using it, but these loans may significantly restrict your flexibility if you run into unforeseen events and can increase the amount of debt you owe even as you make regular monthly payments.