I hate getting into technical mortgage topics and this one is even confusing for
I got so many emails asking me questions about Pay Option mortgages that I decided to go ahead and
tackle the issue. Hang on tight!!!
You have probably seen the ads on TV. “Cut your mortgage payment in HALF!!!!” Get a $200,000 mortgage for under $400 per month!!”
It almost sounds too good to be true!!!!
You have probably seen the ads in the newspaper. Even more creative, they
sound like the ANSWER to your home-buying DREAM!!
“1 Month Option ARM”, “Smart Choice,” “Smart Pay,” “Pay Option ARM,”
“Pick a Payment Loan”, “Cash Flow Option Loan.”
These are all simply well-branded names for what is known as a “flexible
They may have different rules but nearly all share the same main premise.
Lowest payment possible.
Even though you save money on monthly mortgage payments with this type of
loan, you can also lose your some of your equity.
Here is how they work. Once again, each program has slightly different
characteristics. I will discuss the characteristics of the ones of which I am most
Let’s say you borrow $300,000. Each month you will get a mortgage statement
that gives you the choice of up to 4 different payment options. Each month YOU
choose the payment you want to make.
OPTION #1 will be the minimum payment.
This will be the lowest payment based on the Start Rate of your ARM. The first
year this option will be a “teaser rate” that is good for between one to 12 months
and be the one like 1.000%. This minimum payment will change each year.
This is the one to be careful of. Making the minimum payment each month will
very likely mean you will end up owing more than you borrowed.
When your loan is structured so that you can actually OWE more than you
borrowed it’s called NEGATIVE AMORTIZATION. More on this below.
OPTION #2 will be an interest-only payment based on the ARM of the program.
The program is usually is tied to very short-term Adjustable Rate Mortgage, like a
One or Three Month ARM. Although you get to make an interest-only payment,
plan on it adjusting regularly.
OPTION #3 will be a 15 year payment and will pay off your loan as if it were a 15
year payment schedule.
OPTION #4 will be 30 year payment and will pay off your loan at the “Fully
Sounds great but confusing, right?
You should be confused. These programs are very complicated, which creates
an even greater danger that borrowers will take them without fully understanding
I have had many clients come to me for refinances who are currently in these
programs from another lender. Not a single one understood the program and
they had been in it for some time.
The problem is borrowers who don’t understand these programs may someday
be in a mortgage with a payment they simply can no longer afford. They hear
“1.000%” and yell, “sign me up!!!”
The scary about these programs is the negative amortization part that the
lenders do not quite explain properly.
Let me tell you how it really works so you can see the pros and cons.
Let’s say you love Option #1 and for the first 12 months you pay the teaser rate
of 1.00%. On a $300,000 this is around $965 per month. Sorry you can’t do this
When you locked the loan you did this using the Treasury as the index, and the
program has a 2.75% margin.
The margin is the single most important thing to look at when selecting a Pay
Option program. It is usually higher than the rate itself and the lender can
sometimes adjust this for you.
Let’s say when the bank sets your rate, the Treasury is at 2.350 that day. Add
the margin of 2.75% and this means your minimum payment rate is 5.100%.
The interest-only option for the same $300,000 loan would be $1275.
However you decide to take Option #1 that month and pay the 1.000% teaser of
$965. This means you would have “skipped out” on $310 for that month.
Banks don’t like it when you “skip out” so they simply add this to the backend of
your mortgage. You now owe them $300,310. $310 more than you
And this can go on and on.
They usually cap this at between 115-125% of the original loan amount. This
means that you cannot be into them for more than $345,000 on a loan you took
for $300,000 or they will “recast” or refigure the entire loan.
Did you get that? You borrowed $300,000 but if your loan GROWS to $345,000,
they get to automatically recast your mortgage. A “do-over” if you will. Only you
don’t get another 30-year do-over. You get whatever time you have left with a
new, much higher loan amount.
So you bought a $300,000 Pay Option mortgage amortized over 30 years with
four great payment choices but after four years they re-casted it when you got
$45,000 in the negative.
So now you get a brand-new $345,000 Pay Option mortgage with only 26 years left to pay. You can imagine what that does to your new payment.
Negative amortization can be offset by home-price appreciation. That’s another
reason why it was so popular when the market was hot.
However, if home prices drop, as they have recently, you could find yourself owing more than your home is worth.
It is far too risky for buyers to stretch to buy a home using a 1.00%
mortgage, and then make a habit of paying only the minimum amount due each
Are you still with me? Barely? Well, here is where it gets really complicated….
The minimum initial payment is calculated at the interest rate in month one, and
can then, depending on the program, rise by as much as 7.5% of the start rate a year.
This means if the initial rate is 5.000%, it cannot go higher than 5.350% that year.
7.5% of the start rate, not up 7.50%.
That is the yearly cap, so you really can get hurt too bad by the payment the first few years.
While the interest rate jumps in month two, the initial payment holds for the year.
In the four years that follow, each minimum is 7.5% higher than the minimum in
the preceding year. The rate in month one therefore determines the minimum
payments for the first 5 years.
That sounds pretty good. Sounds like you can’t get crushed.
However, the rule that the minimum payment rises by no more than 7.5% a year
usually has two exceptions.
EXCEPTION #1: Every five years the payment must be “recast” to be fully
amortizing. This means if you borrowed $300,000 and you now owe $315,000
because of negative amortization, the bank gets to recalculate the minimums to
help them get caught up, like described above.
They will then recast it over the 25 years remaining regardless of how large an
increase in payment is required. At some point you have to pay
off your mortgage.
If this happens your payment is going to increase substantially, even the
minimum payments. Your loan is for 30 years and at some point you
have to pay back the principal.
Once again, if interest rates skyrocket, but you pay the minimum, you may be
going further into the negative. If they recast your loan, you
may no longer even be able to afford the “minimum” and be forced into a
refinance to keep your house. Or you may just lose it.
EXCEPTION #2: The loan balance cannot exceed a negative amortization
maximum. All of these programs have negative amortization maximums, which
range from 110% to 125% of the original loan balance.
If the balance hits the negative amortization maximum, the payment is
immediately raised to the fully amortizing level. Once again, the bank
does not want to be too far upside down. In fact, these programs usually require
a down payment of no less than 5%. More like 20% if you go with Stated
Either the recasting of the loan or the negative amortization cap can result in
serious payment shock.
I don’t want to simply paint these programs in a negative light. They have some
very real positives as well.
The main selling point is the low payment in the early years. If you plan on only
having this loan for 2-4 years it may the program for you.
However you may be able to accomplish the very same thing with a 1, 2 or 3
year interest-only ARM and not have to deal with the confusion.
Some borrowers find it an excellent way to manage money because it allows
Borrowers who work on commission, or who have a lot of assets but minimal
cash flow, may appreciate the pay option programs.
It allows them to make minimal monthly payments when the cash flow is lower
and when the money starts rolling in, they can pay back deferred
interest and pay down the principal balance.
These programs are also great if you are in a transition period that will mean you
will make more money in the near future. For example, you
started a new job and know that you are getting a pay increase in the next year
or so. This allows you to get in the house you want, make a very low payment
for a few years, and then start catching up.
It’s also a great program for disciplined borrowers who want to pay off a lot of
I had one borrower who was selling his business and wanted to pay cash for his
home with the proceeds. The sale of his business was delayed so he did this
program until the escrow on the business finally closed.
I had another borrower who wanted to pay down his house by $200,000 in the
first two years. He did not want to pay any excess interest and
this was the best means for him to accomplish that.
These programs allow borrowers to buy more costly houses, or use the monthly
payment savings to pay down other debt, improve their homes, or to use their
money for other reasons. They also give you the ultimate control over your
However, as you can tell, they are risky.
The interest rate adjusts monthly, with no limit on the size of interest rate
changes except a maximum rate over the life of the loan. The maximums
generally range from 9.95% to 12.500%.
Almost all of these programs use rate indexes that adjust slowly to market
changes. COFI is one such slow-moving index, others are COSI, CODI and MTA.
The bottom line is this….
Don’t be tricked by a low initial rate, it holds only for one to 12 months. If you
can’t afford the house without the rate being 1.000%,
you are in too much house.
An $800,000 loan at 1.000% is only around $2573/mo. That opens the door for
a lot more people to buy $1 million homes. However can you
still afford the payment if adjustments cause it to go to $4000/mo. and beyond?
Like I said, you may be better served in a short term ARM that is fixed for at least
a couple of years and does not adjust monthly. One that also
won’t ever go into negative amortization.
If you are in love with this program, please feel free to go ahead. They are
extremely popular and people are asking about them all of
However, please make sure your preferred lender understands ALL of
the details. They all get the 1.00% part. That is what they are selling.
If your lender is not well-trained in this program and he locks your margin too
high or chooses a faster-moving index it will cost you $1,000’s yearly.
If you have to explain the program to him, find another lender for this program.
Your focus should be first on the margin, because that is what really determines
Next look at the maximum rate. Look for one under 10.000%, if available to you.
Your third priority should be total lender fees paid upfront. Lenders know you
want this program and are willing to pay for it. They may
charge more than normal.
Shop for the program that works best for you. Right now we offer many different
Banks don’t re-price these programs every day with changes in the market, as
they do with other mortgages. Take your time and shop around. You don’t have
to worry about locking these rates. They rise and drop monthly with the market
so timing it doesn’t make much sense. You should shop margins and max rates
Finally, like all loan programs, these programs come with credit restraints. If you
are planning on going Stated Income, you probably need your credit score to be
over 680 to qualify. If you can go Full Doc, 620 will usually qualify you.
If this program really interests you, you will also want to consider the Secure Option ARM. Its the same principal as above, and a little safer.
The “natural” rate is fixed for five years and your option is to pay 3%-4% less than the natural rate. For example, if the five year fixed rate is 7.000%, you have the option of paying 4.000% for up to five years, or until the loan “recasts” at 115% negative.
Once again, for every $1 you pay under the 7.000%, that amount is added to the bank end of your loan and is negative amortization.
At the time of this newsletter, the average Pay Option ARM was taking about 32 months to recast, if you make the minimum payment each month, while the Secure Option is taking about 36 months.
Aaron Gordon is a top-producing Senior Mortgage Consultant with Realty Mortgage Corporation in Las Vegas, NV. His monthly newsletter currently goes out to over 10,000 real estate agents and other professionals in the Las Vegas area. He helps over 200 families each year with their mortgage needs in many states. He can be reached by email at firstname.lastname@example.org or you can see more newsletters at [http://www.aarongordon.net]