From Elizabeth Weintraub,
Your Guide to Home Buying / Selling.
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In the world of real estate mortgage financing, the most complex loan program is an adjustable rate mortgage product called the Option ARM. Mismanaged, it could cost a home owner her equity. For sophisticated borrowers who understand its nuances, however, it's a brilliant mortgage alternative.

Option ARMs get a bad rap in the industry because they contain a negative amortization (neg am) feature. Neg am is not a bad word. It's not a bad feature. It's mostly a misunderstood term. Neg am lets a borrower tap equity and, if used wisely, is really no different than an equity line of credit. It's a smart loan choice for a person whose income fluctuates from month to month.

Basic Advantage

Depending on cash flow or other considerations, borrowers can choose from among three payment options every month:

1. Minimum
2. Interest only
3. Fully indexed

What is Negative Amortization?

Neg am happens when the monthly payment does not include the full amount of interest due. The amount of interest that is not paid is added to the principal balance due. Option ARMs give the borrower the ability to make a minimum monthly payment, and this payment is less than full interest. Whereas amortized payments reduce your balance and interest-only payments keep your balance the same, a neg am payment increases your loan balance. In the following examples, based on a $200,000 loan, the difference between a minimum payment and fully-indexed payment is $250.

Basic Components of an Option ARM

• Start Rate
  The start rate is generally a "teaser" rate, a very low interest rate, generally good for one to three months. It is also the rate on which your minimum monthly payment is figured.

• Minimum Option Payment
  This is the payment that is typically fixed for at least one to five years. It is less than a full interest payment. On a $200,000 loan, at a start rate of 3.95%, the minimum option payment would be $949.07 per month.

• Interest-Only Option Payment
  As it implies, the payment is "interest only," meaning it pays only the interest due, no principal. At 6% interest on a $200,000 loan, this payment would be $1,000 per month. The interest rate adjusts monthly.

• Fully-Indexed Option Payment
  Adding the index rate to the margin equals the fully-indexed interest rate. [linkurl=http://homebuying.about.com/od/glossarya/g/Amortization.htm"]Amortizing [/link]the loan for 30 years will compute the fully-indexed payment. This will adjust every month. At 6% fully-indexed on a $200,000 loan, the payment would be $1,199 per month. The index rate adjusts monthly.

• Index Rate
  Think of the index rate like the bare-bones minimum return on an investment. It's a rate based on a variety of averaged returns, and is conveniently published monthly. The four basic indexes are:
  1. Monthly Treasury Average
  2. 11th District Cost of Funds
  3. London InterBank Offered Rate (LIBOR)
  4. Cost of Savings Index (COSI)

• Margin
  Think of the margin like the lender's profit. The margin is fixed for the life of the loan and expressed as percentage points. An average margin rate might be 2.75%. It works like this: A lender could say, "I want the same rate of average return that investors get on T-bills. So I will offer this T-bill rate to my borrowers." Say that average rate is 4.00%. But the lender might also want a fixed percentage rate of profit above the average rate. So the lender will add a margin of, say, 2.75 to the 4.00 Monthly Treasury Rate, to earn a fully-indexed rate of 6.75%.

• Payment Cap
  A percentage added to the minimum payment, which represents the maximum amount the payment can increase. Notwithstanding recasting, a typical payment cap might be 7.5%. If your minimum payment is $949.07 with a 7.5% cap, the following year it could increase to no more than $1020.25 per month ($949.07 + 7.5%).

• Lifetime Cap
  This is the maximum interest rate you will ever pay. It is reflected as a percentage. If your start rate was 3.95%, for example, your lifetime cap might be 9.95%.

• Lifetime Floor Rate
  This rate will never be less than the margin rate, meaning your interest rate will never fall below the margin.

• Negative Amortization Cap
  If you make the minimum monthly payment every month, the difference between the full interest payment and the payment you made will be added to your loan balance. That loan balance can never rise to more than 110% to 125% of your original principal balance.

• Recasting
  Many Option ARMs require recalculation or re-amortization every five years. Before the 61st payment, unpaid interest is added to the loan and recalculated. If you have paid large sums toward principal, recasting will lower your future loan payments.

In closing: There are many variations of this loan and hybrid models with twists. Ask for a thorough explanation of each option before choosing, and make absolutely certain you understand the ramifications.