DIYbanter - Option ARM Basic Description:

OPTION ARM

Option ARM Basic Description:

The Option ARM or Option Adjustable Rate Mortgage is a new innovation
in the mortgage marketplace that may very well replace the standard
fixed rate or adjustable rate mortgage as the frontrunner for mortgage
seekers.

Very basically the way an Option ARM works is that you have an
extremely low interest rate for the first 12 to 36 months of the
mortgage. You pay that interest plus the loan amortizes at the 30 year
rate during the Low Rate or Intro period. Many home owners can cut
their mortgage payment in half during this period. After the intro
period expires, no worry, you will generally have a margin from (2.5
-3.75%) over your Index. Indices are usually in the (1.85 - 3.75%)
range occasionally they may jump to as high as 6%. So your effective
interest rate will generally fluctuate between 3.35% and 7.5% and may
jump as high as 9.5% for those with lesser credit during an abnormal
fluctuation in the index rate. Still no worry, most Option ARMS are
capped at 9.5% and have yearly caps of 2-2.5%.

Here is the real beauty of this type of ARM, each month you will
receive a bill with a Minimum payment which reverts back to the
original percentage, an interest only payment where all you pay is the
interest and do not amortize the loan at all, a fully amortized option
where you pay interest and principal at the 30 year rate, or an
accelerated payoff payment where you pay interest and principal at the
15 year amortization rate.

OPTION 1: Minimum payment:

During the first year this is the only option and is fully amortizing
as a 30 year mortgage. After the first year choose this option to let
you keep more cash now and keep monthly payments manageable. The
minimum payment is the smallest amount of interest and, if applicable,
principal that you must pay each month. The payment may not be enough
to pay off the monthly accrued interest charges on your loan and it may
not pay down any of the principal balance. If you make just the minimum
payment, the unpaid interest will be added to the principal balance you
owe, this is called "negative Amortization". It means the amount you
owe increases and you will be charged additional interest on the new
larger principal balance. With the minimum payment, your monthly
payment is set for 12 months at your initial interest rate. This gives
you the opportunity to pay down a good portion of your principal so
that later if you do need to use the minimum payment option it will not
put you into an overall negative amortization situation.

Option 2: Interest-only payment:

After the first year the payment changes annually and a payment cap
limits how much it can increase or decrease each year. You can avoid
deferred interest with this option. With this option you pay the
effective interest rate on the mortgage principal balance. The
effective interest rate is the Margin + the Index. This option does not
negatively or positively amortizes your mortgage your principal balance
remains the same.

Option 3: Fully amortizing payment:

Reduce your principal and pay off your loan on schedule. Fully
amortized payments are calculated each month based on the prior month's
interest rate, loan balance and remaining loan term. When you choose
this option, you reduce your principal and pay off your loan on
schedule.

Option 4: Fully amortizing 15-year payment:

The 15-year payment is calculated to amortize your loan based on a
15-year term. 15 year payments are calculated each month based on the
prior month's interest rate, loan balance and remaining loan term. When
you choose this option, you reduce your principal and pay off your loan
ahead of schedule.

COFI index -

COFI is a slow changing index based The 11th District Cost of Funds
Index is the weighted average of the cost of borrowings (funds) to
member banking institutions of the Federal Home Loan Bank of San
Francisco (the 11th District). The index rate tends to lag market
interest rate adjustments and is relatively stable because institutions
borrow money for varying terms and do not pay market rates for all of
their funds. For example, institutions most commonly borrow from
depositors in the form of certificates of deposit (cd's). The terms on
cd's vary from several days to several years and the interest rates
paid were determined at the time of the deposit.

The last reported rate is: 2.317 %
Effective through April 2005
12 year high 5.617% (COFI) this occurred December of 2000
12 year low 1.758% (COFI) which occurred June of 2004

Add the margin of (2.500 - 3.450%) to the index you choose for your
effective interest rate

The MTA index - Monthly Treasure Average.

This index is the 12 month average of the monthly average yields of
U.S. Treasury securities adjusted to a constant maturity of one year.
In plain English, this index is calculated by averaging the previous 12
rates of the 1 Year CMT. Because this particular index is an annual
average, it is steadier than the 1 Year Treasury Index. It fluctuates
slightly more than the 11th District Cost of Funds Index, although its
movements track each other very closely, as shown in history charts.

The last calculated MTA rate is: 2.171 %
(Note: This rate is updated after the Federal Reserve releases its
data on the first Monday each month.)
12 year high 6.248% (MTA) this occurred august 1995
12 year low 1.225% (MTA) which occurred June of 2004

Add the margin of (2.500 - 3.450%) to the index you choose for your
effective interest rate

For the purpose of a common example loan we have selected the 1 month
MTA as the index and 2.65% as the margin.

The mortgage I am presenting is a common option arm. This mortgage
has a starter rate of 1.25 % and is fully amortizing at that rate for
the first year. Once the first year expires your rate will be the Index
rate plus the Margin. In this case, we assume good credit and low loan
to value ratio, %2.650 will be the margin. So if the COFI is used and
it does not fluctuate, at the end of one year, your effective interest
rate will be %4.967. If you chose the MTA and it has no fluctuation
the effective interest rate at the end of the first year will be
%4.821.

In any case all four options will be available each month after the
first year and an adjusted bill will arrive each month with the exact
amount of each option.

So as you can see this is a very smart solution. Because you can pay
your principal down if you choose to yet if you need to keep more cash
you may also exercise a minimum payment or interest only option without
penalty.

Thank you
Kevin Hidden
http://www.mortgageseeker.biz