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Prepayment penalties: Option ARMs nor-mally have a prepayment penalty to prevent borrowers from refinancing within the first two or three years. Being saddled with negative equity and being unable to refinance to more-favorable loan terms tends to exacerbate the impact of a loan and can become unaffordable for borrowers.
Negative amortization cap: The loan balance can grow as deferred interest gets added to the principal balance. This cannot proceed unabated, and lenders normally cap the negative amortization at 110 percent to 125 percent of the original principal balance. Once this cap is reached, new monthly payments are established as a fully amortizing loan. Even if the negative equity balance is not attained, many loan documents require that the loan be recast every five years.
Subordinate liens: Many second-trust lenders are unwilling to accept a second lien behind a loan that could erode the equity in the house. At best, lenders will determine if there is any "lendable equity" if the loan reaches its full potential negative amortization and base their loan-amount calculations on this amount.
Homeowners' and title insurance: Title-insurance policies must offset potential negative amortization and will include a rider that protects the loan up to its full potential balance.
The margin: Ultimately, if a monthly loan offers a favorable margin, it may still be a competitive choice over longer-term loans. This should be compared to the other interest-only ARM products available, such as the 3/1 or 5/1 ARM. For example, a 5/1 ARM may offer an introductory rate of 5.75 percent. If the monthly option ARM had an index of 3.04 and a margin of 1.75, then the fully indexed rate -- or real interest rate -- would be 4.79 percent. In this situation, a borrower who is aware of the monthly option ARM's features might choose that loan rather than the 5/1 ARM.
Low risk for the lender: Lenders assume the risk of rising or falling interest rates that affect the value of their investments. In the case of the option ARM, lenders take virtually no interest-rate risk. Therefore, lenders are able to absorb more credit risk on an actuary basis. As a result, these loans may offer more-expanded criteria than other investment-grade loans.
In the mortgage business, as in many industries, building credibility with customers is invaluable. Being knowledgeable, aware and dedicated to servicing borrowers in the manner most ideal for them not only ends with closed loans, but begins future relationships with their friends, families, coworkers and acquaintances.
Thomas Morgan is the executive vice president of training for TrainingPro, the national leader in mortgage education. TrainingPro offers state-accredited mortgage continuing-education courses across the country as well as courses designed to enhance careers in the industry such as a complete, formal loan-officer-training curriculum, Marketing Strategies for Mortgage Brokers and Appraisal Principles. For more information on TrainingPro and its course offerings, visit www.TrainingPro.com or call (877) 878-3600.
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