Option ARMs and Cash Flow

One of the standard arguments I hear about negative amortization and Option ARM loans is that they "give the client the option to make a smaller payment if they need to." This so-called "Pick A Pay" benefit is a real benefit, but it's an expensive benefit, one that the client will pay for many times over. They are better off just managing their money well to begin with.



Let's go into some details. Let's consider someone with a $400,000 loan on a $500,000 property, and dead average credit score, and to keep the playing field level, the same 3 year "hard" prepayment penalty. On this morning's rate sheets (outdated by the time you're reading this), I have a 30 year fixed rate loan at 6.00 percent, less than one point total net cost to the consumer. The equivalent Option ARM/"Pick A Pay"/negative amortization loan is actually a little above 7.5 percent real rate, although it carries a nominal rate of 1%. Furthermore, removing the prepayment penalty would make a difference of about an eighth of a percent to the rate on the thirty year fixed, while I have yet to see a Negative Amortization loan that even had the option of buying it off completely, and this loan carries higher closing costs to boot.



Now, let's crank some numbers. That thirty year fixed rate loan has a payment of $2398.21. Nothing ever changes unless you change it by selling or refinancing. The first month, $2000.00 even is interest and $398.21 is principal. You pay for a year, $23,866.38 in interest and $4912.05 in principal is gone, and you've made payments totaling $28,778.43. You are also free to pay down up to twenty percent of the loan's principal in any year without triggering the prepayment penalty.



Plugging in 7.5% for the real rate to keep the math a little easier, the Negative Amortization Loan has four payment "options" of $1286.56, $2500.00, $2796.86 or $3708.05. These options represent "nominal" payment, "interest only" payment, "30 year amortization" payment, and "15 year amortization" payment. Actually, the last three options will vary every month, and trend upwards under these market circumstances, but let's hold them constant just to make my point. As a matter of fact, if you don't make a habit of paying at least the thirty year amortization payment, the options will drift up over time. The chances of this happening in the real world are minuscule, as I make clear in my first article on this subject, Option ARM and Pick a Pay - Negative Amortization Loans, but let's play the game, just to see how it turns out if you give the advocates everything they ask for and more.



Crank the numbers through for twelve months, and you've paid $29,874.96 in interest, $3687.34 in principal, and made $33,562.30 in total payments. This is the "going along, making the loan payments" that the advocates are talking about. Here's a table, comparing this to the 30 year fixed rate loan:

Loan Interest Principal total paid

30 Fixed $23,866.38 $4912.05 $28,778.43

Option ARM $29,874.96 $3687.34 $33,562.30

When you put it in those terms, I don't think there's any question which loan a rational person would rather have. But that's not the situation the advocates would have us believe is beneficial, at least not with this particular argument. Let us presume that two months out of that year - and to keep the math as simple and as favorable as possible, let's make them the last two months - that you decide you have the need to make minimum payments, and let's see what happens. you've paid $29884.40 in interest, lost all but $657.30 in principal payments, and made $30,541.70 in total payments. Now, if you're making the minimum payment more than one month out of six, most folks should agree it's not an "occasional" thing, it's more of a "regular occurrence" thing, which situation I have already done the math to refute any claims of advantage. Here is a table comparing that to the thirty year fixed rate loan:

Loan Interest Principal total paid

30 Fixed $23,866.38 $4912.05 $28,778.43

Option ARM $29,884.40 $657.30 $30,541.70

Look very carefully at that "total paid" row. The thirty year fixed has saved you $1763.27 in total payments. Now, this begs the question of what you're paying it out of, but if you haven't got the income to make the payments from somewhere, you shouldn't have the loan. It's not good for you. So we're assuming that money is coming from somewhere, and as I have illustrated, if you'll just not spend it as it comes in and set a little bit aside in case something happens to your cash flow, that 30 year fixed rate loan leaves you with $1763.27 of your hard-earned money in your pocket. Not to mention just an all around better situation, as evidenced by the rest of the second table.



Now, given the fact that these loans have basically nothing to recommend them to clients, why do alleged professionals keep pushing them off on the public? Well, two reasons, both of them having to do with money. $$$. Coin of the realm. Specifically, commission checks.



First off, it should come as no surprise to anyone that lenders are willing to pay very high yield spreads for negative amortization/Option ARM/"Pick a Pay" loans. The yield spreads start at about 3 and a quarter percent of loan amount, and go up to 4 percent, with most clustering in the higher part of the range. By comparison, that thirty year fixed rate loan pays 1 percent. On a $400,000 loan, like the one in the example, that's the difference between a $4000 check and a $15,000 check. Doesn't that make you feel good that they left you twisting slowly in the wind so that they could make $11,000 extra? Didn't think so.



The second reason that people do this to you is that it makes it look like you can afford a larger, more expensive property than you really can. Most people tell professionals how much property they can afford in terms of monthly payment. Well, shopping for a property or a loan by monthly payment is a disastrous thing to do, as the first part of this article, among many others, illustrates. But let's say you tell the Realtor that you can afford $2500 per month. Now most people are thinking of mortgage payments in the same terms as rent payments, when most people can afford a higher mortgage payment than rent, but let's use these numbers. Let's just use that numbers, and have insurance and property taxes call it a wash. For $2500 per month payments, you can make real payments on a $410,000 property, or you can make minimum payments on a $775,000 property. At 3% buyer's agent commission, assuming they are only representing you and didn't list the property, and assuming they do the loan as well, they can get checks totaling about $16,400 for the buyer's agent commission and loan in the first situation, or $52,300 in the second. Not to mention I don't have to tell the client to limit themselves to what their pocketbook can afford in the second situation. Even here in San Diego, that $775,000 property is a beautiful five or six bedroom 2800 square foot home with all of those nice little extras like travertine floors, three car garage, marble counter-tops, etcetera, in a highly sought after area of town with great schools, whereas the $410,000 property has linoleum floors, no garage, Marlite counter-tops, and is in a neighborhood with marginal appeal and probably not so wonderful schools. Which do you think sounds like a more attractive property and an easier sale, for what the typical buyer thinks of as the same payment? Which property do you think the typical buyer is going to select, particularly if they have never had all of this explained to them?



Finally, for pure loan officers, it's a way of appearing to compete on price without really competing on price. The average person is told about this great 1% payment of $2500 when the real payment for a thirty year fixed rate loan (allowing for the fact that this has become a jumbo loan) is $4771.80, and they just aren't looking at little things like two extra points of origination or higher closing costs, as it just doesn't make that much difference to the payment. They can also slide in a higher margin over index that gets them an even higher yield spread, and it doesn't influence that minimum payment at all, which is the only thing this client has their eyes on. So what if the final payment comes in at $2600 (making the loan officer roughly $35,000 or more)? So what if their loan balance is increasing by $2000 per month? Most people just do not and will not do the work that enables them to spot this trap.



Caveat Emptor.

UPDATED here