The 5-year, Fixed-Payment, Option ARM–The Devil at the Crossroads

There is a famous story about legendary Bluesman Robert Johnson. It is said that while travelling up and down the Mississippi Delta, he met the Devil at a crossroads and sold his soul in exchange for musical genius. Taking an Option ARM�a neg am loan by its former name�is like selling your soul for a low mortgage payment. But what happens when it�s time to pay up?

The Good

Don�t get me wrong. In the right circumstances�a client with fluctuating income or a business owner with unpredictable cash flow�a neg am loan is a great tool. As a former financial planner, I like neg am loans for their ability to better manage cash flow and income taxes. Read my article in the Creating Affordable Payments series. But only one person in 50 has a valid reason to use one. For everyone else,�

a neg am loan is a pact with the Devil.

The Bad

Option ARMs have always had several things going against them.

• The interest rate adjusts every month
• There is no annual interest rate cap
• The payments will rise every year during the early years

The Ugly

As home prices rose and consumers sought ways to achieve lower payments, investors dusted off the neg am loan and tried to make them prettier. First they offered a 5�year fixed payment. Presto, no payment increase! Second, they added a 5 year fixed interest rate. Shazam, no interest rate adjustment! Sounds good, but don�t take the bait. These changes accelerate the rate at which you defer interest and create the most destructive loan ever devised.

Buried in the fine print is this fact. You can only defer interest until the loan balance reaches its limit�typically 110% of the original amount. When you pay at 1% and owe at 8�9%, you hit that limit very quickly.

Example

Let�s use a loan amount of $350,000, a start rate of 1%, and a fully-indexed rate of 9% to see how this works.

$2,816 = your 9% real monthly payment

($1,126) = your 1% minimum payment

$1,690 = deferred interest; the amount effectively added to your loan balance each month

$35,000 / $1,690 = 21 months, the time it takes to reach your 110% ceiling

$3,143 = your new payment

What the Hell Just Happened?

The devil returned for your soul. After 2 years, you max�d out the deferred interest. The lender then recalculated your payment using a) the new balance of $385,000, b) the real interest rate of 9%, and c) the remaining 28 year term. In a heartbeat, your payment tripled. To make things worse, you will pay $15,000 in penalties alone to refinance before the 3�year prepayment penalty expires, not to mention loan fees or sales commission if you have to sell.

So think twice before you head down to the crossroads. If you really can�t afford the payments, don�t sell your soul to the devil to buy that house. You�ll only be more miserable later.

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