You’ve undoubtedly heard or seen ads for mortgages with very low interest rates such as 1.75%. For example, one mortgage company in the city where I live is advertising a 40-year mortgage with a 1.75% interest rate. That sounds like a pretty good deal, doesn’t it? After all, if you were to buy a house for $250,000 with this rate, your payment (not including taxes and insurance) would be only $632 a month.
Maybe this mortgage would be a good deal for you. But before you leap to the phone or fill out an application, make sure you understand how these mortgages work.
They are called option ARMs. This is because they offer four options from which you must choose: minimum monthly payment, interest-only payment, full principle and interest amortized over 30 years, and full principle and interest amortized over 15 years.
If you choose the minimum payment option, which is at the advertised 1.75% interest rate, you pay nothing towards the principle and less interest than what accrues on the loan. The unpaid interest is added to the loan balance, and you become subject to what’s known as negative amortization.
In other words, as you make the minimum payment, your loan balance will continue to grow. And, if interest rates go up, which they are most likely to do, your loan balance will grow even faster, to a point. For example, depending on your loan, when your balance reaches a level, such as 110%, 115% or 125% of the original balance, the loan is “recast, ” and your minimum payment goes up.
There are two dangers to the minimum payment option. The first is that the lower the “teaser” rate (usually 1.75%), the higher the potential increase in monthly payments if the interest rate goes up, as it most certainly will.
The second danger is that you could literally end up owing more than your house is worth, In fact, one economist recently said “They are a lot more dangerous (than an interest only loan) because the borrower is giving away part of his equity, sometimes unknowingly. ”
For example, on a $250,000 mortgage if the balance reached 115% due to negative amortization, the total mortgage would then be $230,000.
It’s difficult to compare a minimum payment option ARM with a five-year fixed rate, interest only loan because pf the differences between the two. However, for the sake of the example, the payment on a $250,000 minimum payment option ARM the first year could be as low as $632. However, because of negative amortization, the balance owed on your mortgage could grow to $210,000 or more by the end of the second year.
In comparison, a 5-year, fixed rate, interest only loan on that same $250,000 at 5.50%, would have a monthly payment of $1145.83. This payment would remain the same for all 60 months (five years) and the balance of your loan would still be $250,000.
So, what lesson is to be learned here? It is that option ARMs can save you money but can be very complex. You need to fully understand what you are doing before you sign up for one. Your loan documents will disclose the risks, so read everything carefully. The documents may have to tell the truth, but marketing materials can be misleading. So read, read, read and if there is anything that isn’t clear, make your mortgage broker explain it until you are certain you understand all the details.
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Douglas Hanna is a retired marketing executive and the author of more than 120 articles on family finances and Internet marketing.