Pick-a-Payment mortgages, also called Option ARMs, are without a doubt the most responsible mortgage structure to come down the pike in a long time and are directly responsible for the linger foreclosure crisis in States like California, Arizona, and Nevada.

Pick-a-Payment Mortgage History

I remember back in the 1995 -1996 hearing about the Pick a Payment mortgage from a wholesale representative of World Savings and it was sold to as a way for “uber rich” borrowers to manage their mortgage with multiple ways to pay.

I was impressed how the rep mentioned sports star who often get bonuses only once a year and don’t really have a “monthly income”. Another example of the typical borrower for an Option ARM was the tax accountant. The idea is tax accountants get the bulk of their income just prior to tax time and their income dries up the rest of the year. The management aspects of the Option ARM allowing larger payments during high income times and lower payments during low income times I could see would be appealing to many self-employed people, not only tax folks.

Pick A Payment Mortgage Payment Options

Option ARM loans have four major types of payment options:

- Minimum Payment

The minimum payment option set for first 12 months at your initial interest rate which in many cases is a “teaser rate” like many credit card offers. After that, the underlying rate changes monthly (complex payment caps control how much it can increase or decrease each year), but the payment only increases or decreases annually. In an increasing rate environment, this creates a shortfall in the interest paid versus the interest owed.

This shortfall is called “deferred interest” and is added to your balance. With continued use of the minimum payment option especially in an increasing rate market, can create a negatively amortized loan if left unchecked could result in an “underwater” situation where the borrowers mortgage balance is higher than the appraised value of the home.

- Interest-Only Payment

The interest-only payment option you can avoid deferred interest also called “negative amortization” that comes with the minimum payment option. The interest-only payment option does exact what is says: pays the interest ony…this option does not result in any principal reduction.

The interest-only payment may change every month based on changes in the ARM index used to determine your fully indexed rate.

- Fully Amortizing 30-Year Payment

This option is just a standard fully amortized 30 year mortgage where you pay both principal and interest. Your payment is calculated each month based on the prior month’s fully indexed rate, loan balance and remaining loan term.

- Fully Amortizing 15-Year Payment

The 15-year payment option allows you to repay your loan twice as fast as the fully amortized 30-year option.

You can see with these options, I could pay a fully amortized 15 year payment when I made a lot as a mortgage broker during the home buying season from April to September…and then pay the “Interest Only” option the rest of the year. I actually ran the numbers and it works out as if I’d just made the fully-amortized 30 year payment year round. Not bad, right?

Wrong!

Three Strikes and You Are Out!

The first problem is this loan is only really appropriate for anyone when rates are falling…as this is an adjustable rate mortgage after all.

Strike 1…

This is a potentially “negative amortizing” mortgage if you only pay the “Minimum Payment” option. This option does not even cover the interest so the unpaid interest gets tacked on to loan increasing the mortgage balance with every minimum payment.

Strike 2…

The fine print of this Pick a Payment mortgage holds some prepayment penalties, adjustment caps, and other terms, that make it only appropriate for truly sophisticated borrowers…financial experts really….not the average mortgage borrower.

Average mortgage borrowers will get suckered into paying the Minimum Payment option and hurt his/her long-term financial position potential pushing them over the edge into foreclosure or bankruptcy.

These options should be clearly marked on your loan statement, but in actuality, they are not. Many lenders “promote” the “Minimum Payment” amount making it difficult to find and pay the other three options. This is clearly a manipulative tactic banks use to increase profits.

Strike 3…

Last I heard, three strikes and you are out!

I only actually closed one Pick a Payment mortgage for a client. He was very sophisticated and rates were dropping precipitously. It worked out for him…but it could have easily gone the other way.

I (and he) got lucky…

Good Luck

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