Flexible-payment mortgages

If you're dependent on bonus or commission checks, an option ARM (also known as a flex ARM) may be the mortgage for you. You pick how much you pay, based on your cash flow.

With most mortgages, your payment is the same every month. But what if your paycheck isn’t so regular? Would you like to be able to vary your mortgage payment depending on your cash flow? An option ARM -- also called a flex-ARM or pick-a-payment loan -- allows you to do just that.

How does it work?
An option ARM is an adjustable-rate mortgage with a twist. You don’t pay a set amount each month. Instead, the lender sends a monthly statement with up to four payment options. You simply tick off the amount you want to pay and send the slip back with your check.

The options vary, but here’s the most common menu:

  • Minimum payment: This is calculated using an “initial rate” that can start as low as 1.25 percent. Because this payment is so low, it’s useful for months when you don’t have much cash on hand, perhaps because you are waiting for a commission or bonus check. Any unpaid interest gets deferred, or added to the principal of the loan.
  • Interest only: You pay all the interest due, but none of the principal. This doesn’t reduce your mortgage balance, but it allows you to avoid deferring interest. (This option isn’t offered if the amount would be less than the minimum payment.)
  • 30-year amortized: This matches the monthly payment of a mortgage amortized over 30 years at your current interest rate. It includes both principal and interest.
  • 15-year amortized: The same as above, but amortized over 15 years. This is the highest monthly payment. Choosing it allows you to reduce your principal faster than any other option.

To illustrate how these payments may differ, let’s assume you’ve taken out a $150,000 mortgage with an interest rate of six percent, and your lender offers an initial rate of three percent for the minimum payment. Your options would look like this:

  • Minimum payment $632.41
  • Interest only $750.00
  • 30-year amortized $899.33
  • 15-year amortized $1,265.79

The fine print
The biggest caveat with option ARMs is that those enticing initial rates are short-lived. The low minimum payments that make these mortgages so attractive can increase dramatically. In addition, every five years the loan is recast -- that is, a new amortization schedule is drawn up to ensure that the remaining balance will be paid off by the end of the loan’s term. When that happens, the minimum payment can be pushed even higher.

What’s more, if you defer too much interest, you can reach what’s called negative amortization. If your balance grows to 10 percent to 25 percent (depending on state law) greater than the original principal, your loan is automatically recast and you have to start paying the fully amortized rate.

Another potential downside of option ARMs is that they’re more complicated than most other mortgages. Home buyers may be seduced without fully understanding how much the minimum payments will increase over the long-term. When the monthly amounts go up, these people can experience payment shock.

Who should consider one?
Option ARMs offer a lot of flexibility for people with fluctuating incomes, provided they are financially disciplined. If you’re a commissioned salesperson, a self-employed professional or an employee of a company that has a salary/bonus compensation scheme, you may want to make minimum payments during lean times, and then make up the difference when the checks you’re waiting for come in. If you’re a seasonal worker, you might pay one of the higher options when you’re actively employed and choose the minimum during the off-season.

 

Published on August 18, 2006
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