One typical structure is called the Option Adjustable Rate Mortgage (Option ARM). The Option ARM goes by a number of aliases: pick-a-payment, deferred interest, negative amortization, NegAm, and others. There are variations on the theme, but these loans all offer flexibility, ultra-low initial payments, and lots of risk to go along with it.
The Option ARM gives the investor the option of picking between four different payment options each month.
Example: Investor enters into a $100,000 Option ARM
• Minimum payment – 1% $322
• Interest only – 7% $583
• 30-year amortization $665
• 15-year amortization $899
The Option ARM is a risky, complicated product with a tempting hook: an ultra-low initial rate. But be aware that there’s no free lunch here. The minimum payment amount is less than the interest rate on the loan, meaning that the principal balance goes up every month that the investor makes the minimum payment.
Option ARMs offer flexibility for disciplined investors who want the option of occasionally minimizing payments in order to divert funds to other investment opportunities, but lately unscrupulous mortgage companies have been hawking these mortgages to cash-strapped homebuyers and investors using the lure of low initial rates. This mortgage is not suitable for buyers who are looking for ways to stretch their dollars.
A good rule of thumb: if the economics of a potential investment don’t look attractive using a traditional mortgage, then an investor should be wary about using an exotic mortgage to improve the investment’s return.
The Author: Chris Smith is a real estate investor, founder of an online reference for investors and real estate professionals and has published articles in Corporate Finance Magazine, Euromoney, and the Business Journal Network. More about Chris Smith.
