Tuesday, June 05, 2007
How to gain the benefits of an "Option ARM" without the drawbacks.
First, let’s go over the basics of an Option ARM (adjustable rate mortgage). Option ARMs go by many different names depending on the lender offering them, but the general idea remains the same, flexibility and extremely low monthly payment options. You’ve probably seen TV commercials or gotten mailers offering too good to be true payments if you are a homeowner (even if you aren’t). These are almost exclusively Option ARM offers. They typically offer at least three payment options; fully amortizing (principal and interest), interest only (just interest), and lowest payment (less than just interest). Generally, people use Option ARMs to control their monthly cash flow because the loans have payment options that are lower than any other type of loan. In a moment I will cover a strategy to accomplish this without the negative aspects of an Option ARM.
Without getting into the technical business of caps/margins/indexes, Option ARMs are able to offer lower payments than other loans because the lowest payment option is negatively amortizing. In other words, you are using a little bit of your equity each month to subsidize your mortgage payment and keep it artificially low for cash flow reasons. If you are knowledgeable about financial matters and have no problem with a little risk, these loans can be a great tool. In my opinion, most people not heavily investing or not in a rapidly appreciating market should avoid them.
The drawbacks of Option ARMs are possible negative amortization, higher rates than comparable conventional mortgages, tougher guidelines for loan approval, and a higher likelihood of prepayment penalties. As I write this in June 2007, the actual rate that the best qualified borrower is paying on an Option ARM is somewhere between 7-8%. Even if the start rate or teaser rate is 1% (I’ve even seen 0.95%), the rate that the borrower is actually paying on their money is over 7%. The difference between the start rate, which determines the payment, and the actual rate, which determines how much interest you pay, over 7% comes out of the equity of the home each month.
So how do we get the benefits of an Option ARM without the drawbacks? The answer is a Mortgage Reserve Fund (MRF). An MRF is simply a checking or savings account that your mortgage payment is drawn from each month. I think savings accounts work better because of the limited accessibility to the money.
The MRF is established when a borrower deposits money from the equity in their home after a refinance. The borrower then automatically pays their mortgage with the MRF each month and deposits the amount they were going to pay to the lender into the MRF account. In other words, rather than having small amounts of equity taken off the top every month by the negatively amortizing loan, the borrower is managing these equity payments themselves. The amount to start the MRF with is determined by multiplying the number of months a borrower wishes to subsidize their mortgage payment by the amount they wish to subsidize every month. For instance, if you wanted to lower your monthly payments by $200 a month for 2 years (suppose you had a child with two years left of college), you would take out $200 x 24 months ($4,800) extra during the refinance process to start your MRF.
In our example, if a borrower was refinancing $100,000 and was considering an Option ARM because it had the option of payments that were $200 lower than a conventional loan, they would simply refinance $104,800 and start a reserve fund to accomplish the same goal, but with some added benefits.
One major benefit of an MRF is that it can be matched with any loan because it happens after the loan process. Another is that it acts as a sort of buffer for your mortgage payment. If you contribute to your MRF fund a little late, it’s ok because your mortgage payment is still automatically drawn from that account and it has extra room built in. Not to mention the fact that you have money handy in the case of an emergency. Lastly, and most importantly, you are able to qualify more easily for a mortgage with lower rates and less chance of a prepayment penalty. You would not be subject to the stricter guidelines and program limitations of Option ARMs because you can choose any program you wish and turn it into something that behaves in the same way as an Option ARM.
Many people would probably argue that it isn’t smart to take equity out of your house because you have to pay interest on money that you aren’t directly using. I believe the difference is negligible because you can use a high interest savings account as you MRF (they are available over 5% currently). On a small amount of money, this difference shouldn’t make a large difference and the benefits far outweigh this drawback. The idea of paying 1% or more less in interest on your entire mortgage balance should convince you that the small amount of negative interest you are paying on the money in your MRF is insignificant.
This concept is fairly advanced as far as mortgages go, so feel free to contact me if you have questions regarding this topic or any other mortgage related concern. If you live in Arizona, I would be happy to help you set up an Mortgage Reserve Fund with your refinance.
Without getting into the technical business of caps/margins/indexes, Option ARMs are able to offer lower payments than other loans because the lowest payment option is negatively amortizing. In other words, you are using a little bit of your equity each month to subsidize your mortgage payment and keep it artificially low for cash flow reasons. If you are knowledgeable about financial matters and have no problem with a little risk, these loans can be a great tool. In my opinion, most people not heavily investing or not in a rapidly appreciating market should avoid them.
The drawbacks of Option ARMs are possible negative amortization, higher rates than comparable conventional mortgages, tougher guidelines for loan approval, and a higher likelihood of prepayment penalties. As I write this in June 2007, the actual rate that the best qualified borrower is paying on an Option ARM is somewhere between 7-8%. Even if the start rate or teaser rate is 1% (I’ve even seen 0.95%), the rate that the borrower is actually paying on their money is over 7%. The difference between the start rate, which determines the payment, and the actual rate, which determines how much interest you pay, over 7% comes out of the equity of the home each month.
So how do we get the benefits of an Option ARM without the drawbacks? The answer is a Mortgage Reserve Fund (MRF). An MRF is simply a checking or savings account that your mortgage payment is drawn from each month. I think savings accounts work better because of the limited accessibility to the money.
The MRF is established when a borrower deposits money from the equity in their home after a refinance. The borrower then automatically pays their mortgage with the MRF each month and deposits the amount they were going to pay to the lender into the MRF account. In other words, rather than having small amounts of equity taken off the top every month by the negatively amortizing loan, the borrower is managing these equity payments themselves. The amount to start the MRF with is determined by multiplying the number of months a borrower wishes to subsidize their mortgage payment by the amount they wish to subsidize every month. For instance, if you wanted to lower your monthly payments by $200 a month for 2 years (suppose you had a child with two years left of college), you would take out $200 x 24 months ($4,800) extra during the refinance process to start your MRF.
In our example, if a borrower was refinancing $100,000 and was considering an Option ARM because it had the option of payments that were $200 lower than a conventional loan, they would simply refinance $104,800 and start a reserve fund to accomplish the same goal, but with some added benefits.
One major benefit of an MRF is that it can be matched with any loan because it happens after the loan process. Another is that it acts as a sort of buffer for your mortgage payment. If you contribute to your MRF fund a little late, it’s ok because your mortgage payment is still automatically drawn from that account and it has extra room built in. Not to mention the fact that you have money handy in the case of an emergency. Lastly, and most importantly, you are able to qualify more easily for a mortgage with lower rates and less chance of a prepayment penalty. You would not be subject to the stricter guidelines and program limitations of Option ARMs because you can choose any program you wish and turn it into something that behaves in the same way as an Option ARM.
Many people would probably argue that it isn’t smart to take equity out of your house because you have to pay interest on money that you aren’t directly using. I believe the difference is negligible because you can use a high interest savings account as you MRF (they are available over 5% currently). On a small amount of money, this difference shouldn’t make a large difference and the benefits far outweigh this drawback. The idea of paying 1% or more less in interest on your entire mortgage balance should convince you that the small amount of negative interest you are paying on the money in your MRF is insignificant.
This concept is fairly advanced as far as mortgages go, so feel free to contact me if you have questions regarding this topic or any other mortgage related concern. If you live in Arizona, I would be happy to help you set up an Mortgage Reserve Fund with your refinance.
