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   ARTICLE   |   From Scotsman Guide Residential Edition   |   January 2005

Option ARMs vs. Interest-only: What’s the Real Bottom Line?

The advertisements state: “1%, 1.25%, 1.95% … We have the lowest rates around!” Meanwhile, consumers just shake their collective heads and wonder, “How can they do this?” It’s no secret the explosion of alternative mortgage programs has outpaced many a borrower’s ability to comprehend either their benefits or pitfalls. What may be more frightening, however, is the number of brokers who do not fully understand the nuances (both positive and negative) of the different programs they are actually trying to sell.

A few years back, life was simpler. There were 15- and 30-year mortgages, a few ARMs, the occasional option program, and FHA and VA loan packages. Rates and closing costs varied, but the industry, for the most part, was stable and predictable. Ah, for the good old days!

Now, it’s “Katie, bar the door!” Just think of a new loan option, and a week later it’s an industry standard. Call it “keeping up with the Joneses” or just the inevitable result of a growing, competitive environment. Whatever the reason, the results have been nothing short of astounding.

Few programs, however, have inspired as dramatic a shift in thinking as the Option ARM. At every level, from brokerage house to lender and from loan officer to borrower, everyone has had to change his or her thinking process.

Once it was about access to a simple mortgage; now it’s about getting more house for less money and playing the leverage game along the way. Once we had lenders, loan officers and borrowers; now we now have investors, facilitators and speculators. Owning a home is equated with “investing for eventual profit-sharing,” and the Option ARM is the game plan many are using. But is it the right one? Let’s do a little comparison shopping.

Comparison Shopping

When is a 3.875% payment cheaper than 1.25% payment? First, let’s make some assumptions in our example:

  • The buyer (or refi customer) understands the basic principles of the Option ARM program (significant increased cash flow, potential negative amortization and prepayment penalties, appraisal challenges, margins, etc.)
  • This same buyer has made a decision that the immediate cash-flow rewards outweigh possible downsides and that his/her income can absorb any negative hits, if necessary.

To the sophisticated homebuyer, as well as to a number of loan officers, it would seem obvious that an Option ARM with an interest rate of 1.25% would be preferable to any other loan program on the market with a 3.875% rate and that shopping for the best minimum payment rate would be all that’s necessary to achieve “cash-flow nirvana.”

Although it may seem that way, that doesn’t necessarily make it so. Let’s continue our comparison shopping.

Option ARM Specifics:

Loan amount: $350,000

Rate: 1.25%*

Rate Change: Monthly

Margin: 2.50%*

Index: 1.708%*

Min. Payment: $1,166

IO Payment: $1,228

Although either payment above is dramatically better than a 30-year fixed at 6% ($2,100/mo), it might surprise you to know that a generic six-month interest-only LIBOR ARM program can be a better deal on a number of fronts. Let’s examine those specifics:

Six-Month LIBOR ARM Specifics:

Loan amount: $350,000

Rate: 3.875%*

Rate Change: Every 6 months

Margin: 1.875%*

Index: 1.98%*

IO Payment: $1,130

Now let’s take a further look:

  • Lower monthly payment for six consecutive months. Although no one can tell what the future will bring, based on the last few years (even with the trend going higher), rates are not likely to go higher in a dramatic fashion and may still go lower.
  • Lower interest-only payments. Do you want to drop the negative amortization possibility on the Option ARM? Fine, but your IO payment will still be higher.
  • Lower margin will remain, regardless what index rates do, and this margin is lower.
  • No negative amortization accumulates on the loan.
  • Stated or full doc with no hits. This may or may not be the case with an Option ARM program, depending on a number of issues.
  • No prepayment penalty. Although not always true, the vast majority of these programs are prepayment penalty free.
  • LTVs and appraisals are not always on a par with the six month (IO) LIBOR guidelines. Both can be less than hoped for with Option ARMs, depending on the lender.

Is there a downside to this type of IO loan package? You bet! Higher rates are a given. If rates do go dramatically higher, then the Option ARM with its fixed payments (usually a 7.5% add-on to the minimum payment annually) will assure a generous continuing cash flow. Of course, it may also assure a significant amount of negative amortization at the same time, but you knew that going into the program.

Which program is better for your clients? You and the clients will have to make that decision, but at least do it with all the facts. Take the “obvious” out of the equation, and do a little means testing and number crunching to be sure. You know what they say about those that assume rather than prove.

*Rates effective on September 1, 2004.

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