The Pay Option Arm and Pick-a-Payment Loan are the most radical and creative loan programs available today. They both are the same loan product, for sake of this article we will be referring to it as the Pay Option Arm. It is sometimes the perfect choice for the potential borrower. Unfortunately many borrowers are choosing the Pay Option Arm without fully understanding the parameters of the loan. I’ve said it before in past articles, when something sounds too good to be true, that is usually the case. To many, the idea of saving thousands of dollars a year in mortgage payments is all they need to hear, but further investigation might change their minds. Just like all loan programs, the Pay Option is the right choice for some and the wrong choice for others.

Most borrowers want the lowest mortgage payment on their home. The Pay Option Arm will give you the lowest mortgage payment available today, with many offering a 1% start rate. Nothing will get you a lower interest rate. Each month you are given four payment options; a minimum payment, an interest only payment, a 30 year payment, and 15 year payment. Your actual interest rate is adjustable from the start of the loan, usually adjusting every month or some adjust every three months. Most have a prepayment penalty between one to five years; the penalty is usually 6 months interest. Now those are just the basics of the Pay Option Arm. How the actual interest rate is calculated is what most never learn or understand.

The 1% interest rate is your start rate, meaning you will have an option to choose a payment based upon a 1% interest rate amortized over 30 years. This, however, is not your true interest rate. Your true interest rate is calculated by adding your margin to the index. Generally there are three indexes’ to choose from when selecting a Pay Option Arm. We could dedicate a full article to the discussion of which index to choose and why, but for simplicity we will work with the COFI index (the cost of funds index). The COFI is currently at 2.183%, and a typical margin might be roughly 3.35%. When you add the two together (the margin and the index) you get your true interest rate, 5.533%. Obviously a lot higher then the 1% start rate you can choose to make a payment based on.

Another name for this product is the Negative Amortization Loan or “Neg Am”. Some lenders kindly refer to is as deferred interest. They both mean the same thing, but one sounds more appealing than the other. Negative amortization occurs when the borrower is making a payment less than the actual interest accruing on the loan balance. This is best demonstrated by example. The minimum monthly payment with a 1% start rate on a $200,000 loan amount is $643.28 a month. The actual accruing interest on that loan with a true interest rate of 5.533% is $922.17 a month. That leaves a difference of $278.89 a month that is deferred interest. This deferred interest gets added on to the loan balance, after the first month of making the minimum payment the new loan balance would be $200,245.05. Your next month’s interest is now calculated by using this new loan balance, creating compounded interest.

Pay Option Arm Home Loan of $200,000

The Four Payment Options Payment Balance Reduction 1% $643.28 +$278.89 Interest Only $922.17 $00.00 15 year $1,637.67 -$749.34 30 year $1,139.72 -$251.39

The example above shows how much difference each option makes towards your principal balance. The truth is very few people choose the options of the 30 and 15 year principal and interest payment. If a borrower can afford the 30 or 15 year payment they have probably selected the wrong loan program. Why? Fixed rate mortgages have been under the six percent for quite some time now. You don’t want an adjustable rate mortgage that is already at 5.533%, and expected to continue to climb, when you can fix your interest rate for 30 years at 5.50%. So who chooses the Pay Option Arm and for what reasons?

Honestly, for most it is the low payment that lures them in. For those who thought they could only afford a $300,000 home, the Pay Option Arm gives them the same payment as a $450,000 home. This can make quite a difference in the quality of your home, but what about all the deferred interest? Some of my borrowers are not worried about the deferred interest considering home values have been soaring in recent years. Even though they might add $4,000 a year to their loan balance, if their home appreciates $20,000 a year the investment still works. It does pencil out, but you definitely aren’t going to pay your mortgage off this way.

Some loan officers sell this loan based upon its flexibility, the four payment options. For those who have flexible budgets from month to month it might be beneficial to have several payment options. However, if flexibility is needed I recommend choosing a different product. Getting an “Interest Only Option” fixed mortgage will give you the option each month of how much to pay each month towards principal without the possibility of deferred interest. With the Pay Option Arm you are not saving money each month, you are simply borrowing more. You can either pay now, or even more down the road.

I have two types of clients that choose the Pay Option Arm. The investors who are planning on holding on to the loan for a short period of time and don’t mind the deferred interest since they are planning on making a considerable return. The other type is the home buyer who is willing to do what ever it takes to get them into the home they want. They need the lower payment now and are expecting to make more money in the future and afford a fixed rate mortgage at a later time. In this case I make sure they understand all the possibilities associated with the Pay Option Arm before making the decision.

The index’s that these Pay Option Arms follow have been soaring upwards, some as fast as .1% every month. Don’t let the start rate fool you. Most Pay Option Arms will have an actual interest rate above 6% very shortly unless something drastically changes with interest rates. Unless they fit one of the two types mentioned in the previous paragraph, I find myself steering potential borrowers away from this product. Unfortunately, a lot of loan officers really push this product on their clients. The banks pay loan officers a lot of money to sell this loan, and some put greed before their clients’ best interest. This article just touched on a few points of the Pay Option Arm, hopefully enough to where you can make an educated decision.