Creating Affordable Payments (Part V): Pay Option ARMs

Okay, in our effort to create affordable payments, we laid a foundation with the 15 and 30 year fixed rate loans in Part I.  We stretched the repayment term out to 40 and 50 year loans in Part II, and then looked at shorter term intermediate arms—the 3/1, 5/1 and 7/1–-in Part III.  In Part IV, we looked at interest-only loans that eliminate the principal portion of payments entirely.  

Now, let’s pull the cover off the Pay Option ARM and see what lies beneath.   Is this controversial creation a useful tool or a dangerous weapon?  Will it solve a unique challenge or insinuate itself into your life like a Trojan Horse only to destroy your dream of home ownership from within?  Opinions on Pay Option ARMs tend to come in black and white.  But nothing in life is that simple, is it?

To begin, let’s get something clear.   There is no such thing as a 1% mortgage.  That should go without saying.  But I am continually amazed at all the smart people who believe in ghosts.  We’re all guilty of wishful thinking, but if you really believe you could get a 1% rate when all your friends were getting 6%, then perhaps you deserve a surprise.   As my financial planner says about foolish investing, money tends to be returned to its rightful owner. 

Pay Option ARMs are easy to understand when viewed in context.   The last stop after allowing a borrower to pay just the interest, is to allow the borrower to defer some of that interest.  If the borrower waits until he refinances or sells, the deferred interest is added to the loan balance and the loan balance is bigger than it was at the beginning.  But that is generally a bad idea.  So is using this loan to buy a home you cannot really afford.   

Here are a couple of examples of positive ways to use a Pay Option ARM.  

Case Study #1

A client of mine works for a technology company.  With half the globe as his sales territory, he has the potential for enormous commissions.  But he is never quite sure when the big checks will come in.   I have him make the minimum payment during the year until that incentive pay materializes.  If that happens in December, I have him pay all the deferred interest then.  If the commissions arrive in the next calendar year, I have him pay the deferred interest then.  He pays the interest when he has the income to do so and when he is in a higher tax bracket.  The Pay Option ARM has become a valuable tool for managing both cash flow and income taxes.   

Case Study #2

Another client recently got divorced after buying a large home a few years ago. Unable to afford the payments on his own, his only choice appeared to be to sell the home in an unfavourable market, throwing away over $50k in commission and costs and relinquishing control of an appreciating asset in a prime neighborhood.   By using a Pay Option Arm, we were able to create a payment he could afford and allow him to keep the home until the market improves.  Even if he never pays the deferred interest, it will take over 5 years to defer interest equal to the equity he would immediately lose if he sells.  During that time, the home may appreciate, his income may rise, or he may remarry.  Any of these things could enable him to catch up any deferred interest.  

When You Have a Hammer, Every Problem Looks Like a Nail

Unscrupulous lenders sell Pay Option ARMs to everyone.   Why?   Because they can can jack up the nearly invisible margin, throw on a 3 year prepayment penalty, and earn 4 points in rebate.  And it’s so easy to sell, especially if you leave out a few important details.   In my estimation, only one or two people out of fifty have a valid use for a Pay Option ARM.  

But for those few, a Pay Option ARM may be the best financial planning tool we have for managing cash flow and maximising income tax deductions. 

Share This