The Pay Option Adjustable Rate Mortgage (or Negative Amortization)

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

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, 11th 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.

There are some interesting facets to an equity line of credit which make it a very valuable loan. It allows you to control your payment and cash flow on a monthly basis and because you have an interest-only loan, you can make a minimum payment and still tread water. Beyond that, you can pay extra money towards the principal any time you want.

The nice thing about it is that your payment is based upon the existing balance you presently owe.

Example

Let's say you have an equity line of credit with a monthly payment of $100 based upon the fact that you currently owe $25,000. If you pay an extra $2,000 on that line of credit this month, then next month your balance is $23,000. Like a credit card, when your payment coupon arrives the next month, your payment will immediately decrease because that payment is based on the balance you owe, not on the original indebtedness as in a fully-amortized fixed rate note.

Where it differs from a credit card, is the fact that it's tax deductible. This is the part of the equity line of credit that is beneficial to you, the client. In fact, you can take all of your credit card debt and pay it off with one new loan as an equity line of credit, thereby creating a tax deduction you don’t presently have with your credit card debt. Beyond that, another interesting component to it is the ability to draw back against it at any time.

What happens is that you get a checkbook in the mail when you receive your first payment coupon. This checkbook is your means for drawing back against the equity line once you have paid it down. If you originally borrowed $25,000 and over the course of three years you pay the note down to $18,000 and then decide you need to borrow money to buy a new car, you can write a check against that line of credit.

This way you could pay for the car on your equity line and have it become tax deductible. It adds flexibility and increases your tax write-off.