Option Arm Mortgage Loans: How do they work?

Typically, option arm mortgage loans give the consumer four payment options each month - a 30year fixed payment, a 15 year fixed payment, an interest only payment and a deferred interest or minimum payment.

The 30 year, 15 year and interest only payments are based on the fully indexed rate. The fully indexed rate is calculated by adding the margin to the index. The index would most likely be the Libor, MTA, COSI, COFI, or CODI.

Here’s an example:

Let’s say you have a margin of 3.15 and an index of 3.32. This would give you a fully indexed rate of 6.47% (3.15 + 3.32 = 6.47). This is the rate that is used to compute the 30 year, 15 year, and interest only payments.

Depending on the lender and loan program you select, the deferred interest or minimum payment could either stay fixed between 1% and 2% for 5 years or the PAYMENT could start at around 1% and go up or down a maximum of 7.5% annually for 5 years.

The minimum 1% to 2% payment is an interest only payment and is based on a 30 or 40 year amortization.

The reason an option arm loan is called a deferred interest or negative amortization loan is because the difference between the minimum 1% payment and the interest only payment is added to the loan amount each month if the consumer chooses to make the minimum payment. So the loan balance increases over time instead of decreasing.

Once the loan hits the 5 year mark or if the deferred interest reaches 110% or 115% of the original loan amount, the loan will recast. Which means it will convert to an interest only or principal and interest loan at the fully indexed rate.

The fully indexed rate is calculated monthly and therefore could change from month to month.

Here are a few benefits of the option arm mortgage loan:

* The minimum payment is 100% interest; therefore, 100% of the payment is tax deductible

* The deferred interest is mortgage interest so it may be tax deductible

* If the client makes bi-weekly payments, the amount of deferred interest will decrease by approximately 30% or be completely eliminated.

* The minimum payment increases the client’s cash flow

* This loan gives the client several payment options

* It also allows clients to use their mortgage as a financial tool to build wealth.

In closing, here are four important points to keep in mind when selecting an option arm loan program:

1) Get a 30 year amortization (not 40 years). The 30 year amortization will keep the 1% payment option available longer.

2) Choose an index which is less volatile. Like the MTA instead of the Libor.

3) Select an option arm program that has a 115% recast instead of a 110% recast to increase the chances of the payment options being available for the full 5 years.

4) Select an option arm with a low lifetime interest rate cap

For more information on this and other mortgage related topics, please visit:

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