Saturday, October 3, 2009

Option ARM Loans – Know the Dangers

One of the most popular mortgage products in the market are option ARM loans. You may have heard a lot about them and even heard a lot of negativity around option ARM loans. The truth is, if you understand a mortgage product and use it correctly, risks and downsides can be significantly minimized, leading to an optimal financial strategy to get you into the home of your dreams and reap the benefits of an appreciating home price.

Generally speaking, newer and more complex loan products such as option ARM loans should be used with extreme caution. They are typically difficult to understand, and if used incorrectly, they can lead to the loss of your home very quickly. A good rule of thumb is to only use option ARM loans if you understand them really well, or else you can find yourself in trouble very quickly. You shouldn’t avoid the product altogether, but the key is to make sure you understand the product before you sign the dotted line and commit to the loan.

The way option ARM loans work is that they are adjustable rate loans which provide several payment options for a borrower. The payment options have a wide range and can be extremely cheap, making the loan enticing. Sometimes, the lowest monthly payment option is one-third to one-fourth of a 30-year mortgage. If the cheapest payment option is selected, the home owner will accrue unpaid interest which needs to be paid at some point. If enough accrued interest accumulates, the home owner’s loan will recast, causing a huge balloon payment to reduce the amount of accrued interest. Often, a borrower is unaware of this “shock” payment and unable to pay it, causing the borrower to go into default and lose his / her home. Alternatively, if the home owner chooses to pay the full interest payment each month, the option ARM becomes equivalent to an interest only loan. In another payment option, the borrower can pay interest plus principal, making the loan more like a 5/1 ARM.

As you can see, the option ARM can be a complex product that gets a borrower into trouble. However, there are ways to use the option ARM properly and minimize your risk exposure. First, make sure you have enough equity in a home so that you do not default or go bankrupt if the loan recasts and home values have not increased enough for you to get a new loan. Second, make sure you know when the loan will recast so that you are prepared for your options, whether it’s get a new loan, sell your home, or make a large lump sum payment. Generally, you want to leave enough room in your financial portfolio so that you can avoid default and bankruptcy. It often is a combination of equity in the home as well as a cash safety net.

If used correctly, an option ARM loan can be a great financial vehicle. For example, if home values are increasing, you can pull out equity by taking out another option ARM loan and paying off your first loan. This way, you build equity in your house with minimal monthly payments, allowing you to invest the money you’ve saved. The key with the option ARM loan, like all others, is to know exactly what the product is so that you are prepared for what comes your way. If used correctly, the option ARM loan is a fantastic way to build a portfolio of property and wealth.

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