The Pay Option Adjustable Rate Mortgage (or Negative Amortization)

1. Minimum Mortgage Loan Payment
   
   
2. Interest Only Mortgage Loan Payment
   
   
3. 30 Year Amortized Mortgage Loan Payment

Certain types of Adjustable Rate Mortgages have a feature that is known as the Pay Option ARM or Negative Amortization. This loan has a bad rap and to some degree rightfully so. The negative stigma that is associated with this loan is simply the consumer not understanding the loan and the mortgage professional not doing a good job of educating them on how the loan works.

A Pay Option ARM has three payment options on a monthly basis. It is from these three payment options that we derive the Negative Amortization feature. An explanation of the three options is given in the following hypothetical example to make it easier to understand and comprehend this component.

Option #1 is to pay the minimum payment at an introductory rate of 2.95%. Now on a Pay Option ARM (Negative Amortization), the payment changes annually, but the important distinction is the interest rate changes monthly. This becomes very confusing for the consumer. They say, 'How can the interest change monthly but the payment only changes annually?'

You are offered this introductory rate at 2.95% and beginning in month number 2, the Lender will take that fixed margin and add it to the varying index (LIBOR, MTA, 11 th District Cost of Funds, etc).

Lets say those two added together come to 6%,

Option # 2 in the month number 2 of your loan payment is to pay an interest only payment at 6%, which is the addition of Margin + Index.

Option # 3 would be to pay a principal and interest payment, associated with 6% fully amortized over 30 years.

In summary, your options are to pay the 2.95%, pay an interest only payment of 6%, or pay a principal and interest payment, which is on a fully amortized 30-year note associated with that 6% interest rate.

Let's say the payment of 2.95% is $1,000 a month, and you can pay that payment starting in month number 2. However, if you do, the difference between that payment and the interest only payment at 6% gets tacked on to the principal balance that you owe on your home. So, if you originally borrowed $100,000 and the interest only payment is $1,400 a month and you pay $1,000 a month, (that is equivalent to the 2.95% in month number two), that $400 difference between $1,400 and $1,000 gets added to how much you owe on your home, hence negative amortization.

Your principal balance is increasing and you are literally tapping into the equity on your home to control cash flow. This is why in some cases this loan is perfect for certain consumers. If you are in sales, or you are an accountant that receives income on a seasonal basis, maybe there are several months out of the year where money is tight. In those set of circumstances this loan could work very much in your favor. You can make that negatively amortized payment and almost use it as an equity line associated with your house to make a lower payment, tapping into the equity to buy time for the rainy days to end so to speak. At the point when your cash flow is better, you can make up the difference by prepaying the principal.

You are once again given three options, which lends to the flexibility to one's monthly indebtedness and for that particular reason this type of loan is a good loan for certain people.