Greely
05-05-2006, 03:52 PM
Option ARM / Cash Flow ARM / MTA ARM Course 101 1:51 PM 5/3/2006
Another thread was derailed talking about these loans and I said I would post a new thread explaining the inner workings of these types of loan to educate potential borrowers and even brokers.
These loans gained their popularity in the last few years with the idea of taking equity out of your home and using that equity to make money and theoretically pay off this loan a lot sooner. Although I’m not a big fan of messing with equity, especially if you are going to risk it trying to make money, but if you feel like this is your gig, be my guest, just know that there are better loan products out there and hopefully you will see why.
As I said, these loans became the “hot loan” to sell within the last four years. The reason I believe they became the hot seller is that the lenders needed something to entice borrowers away from the lowest fixed and short/long term ARM rates in history. How did they do this? They promoted them as “Cash Flow ARMs” with the sell of having a low mortgage payment while you use the difference between available conventional financing to invest or pay off other debts. Below you’ll see why these loans were pushed by the lenders and why they paid brokers 1 to 2% more in yield spread comparable to conventional loans to sell them.
The Option ARM, Cash Flow ARM, or MTA Option ARM are really all the same dog with minor variances. Basically, you finance your property and each month you are sent a mortgage bill with 4 options of payments. The first is the “cash flow option or minimum amount due”, the second an interest only (IO), the third a fixed 15, and lastly a fixed 30 year option. Really every thing revolves around the interest only payment, that is your base mark and that is the interest rate use for the IO, and fixed options. The cash flow/minimum option is actually based on a very low rate, usually in the 1% to 2% range. Now let me go over how the payments work.
Interest Only- Like I said, everything revolves around this payment. You will be given an index for which a margin is added to get you interest rate. Usually the index is the MTA, COFI, 1 Month Libor, etc. and when added to the margin is usually equal or, depending on your margin, higher than the going fixed 30 year conventional mortgage rate. If you choose to make this payment nothing happens, you pay the interest for borrowing the money, nothing more nothing less. If you borrow $100,000 and make the IO payment for 30 years you will still owe $100,000. Now the catcher and this is why these loans were sold at the lowest fixed rates in history, is this rate can change every month, based on what the index has done. So if you signed up for this loan 3 years ago, your rate has gone up at least a percentage or two. Basically it is a 1 month ARM loan.
15 or 30 Year Fixed Option- This option is really a misnomer, it is actually a 15 or 30 amortization option. The same 1 month adjustable rate as calculated above is plugged in and using either a 15 or 30 year amortization, your payment is calculated. Now, this payment will have both interest and principal reduction within the payment, but the payment is calculated as if it were the first payment of the whole loan every month, meaning you are always making 1 out of 360 (30 yr) or 180 (15yr) payments, and as everyone knows the first payments on either fixed rate loans are interest stacked. Again, just to clarify, the rate that is used to calculate the 15 or 30 year fixed option is actually the interest only rate as calculate above, which, once again, can adjust every month. It is not a fixed rate, but a fixed amortization. Think of it as that old trick of walking half the distance to a wall each turn, you will never reach the wall no matter how many turns you take. The same thing is happening here, but instead of going half way you are only going 1 step out of 360 to the wall (payoff of the loan).
Cash Flow/Minimum Payment- If the above isn’t enough to drive you away from these loans, this part will do it. Once again these loans were sold as Cash Flow mortgages, make the minimum payment and invest the difference, you’ll be rich!! Well if you choose this option this is the reality. The difference between the minimum payment and the IO payment gets ADDED to the principal you owe, which is called negative amortization. In reality it may not seem like a lot each month, but you have to remember the same compounding interest principals that apply when you pay a little each month on top of your generic 30 year fixed rate (1/12 of the scheduled payment amount) will cut about 7 to 10 years off of your mortgage. Now think of that in reverse, a couple of years of that and you could owe a lot more that you originally borrowed.
Now don’t worry, the lender has triggers in place that if you get upside down more than 15 or 20% they will recast the loan using the new balance (ie higher payment across the board). Now not only are you paying interest, but you are paying interest on interest you neglected to pay using the cash flow amount and owe 15 or 20% more than originally borrowed. Mind boggling. To cap off the salt in the wound, the lender will sell you a fixed option on the teaser cash flow rate, which is great….for the lender. They don’t want that rate to go up, they want as much spread tacked onto the principal as they can, ending the teaser rate and it going to say 5% will just lessen the interest they can charge interest on again. So yes, a 5 year fixed option sounds great, in reality the lender is handing you a bigger shovel.
These loans were pure genius for the lenders. They took borrowers that would have locked in a low rate (remember they were the lowest in history) into basically a 1 month adjustable rate mortgage, with the potential of negative amortization and remember the rates they offered for this 1 month arm were basically the same as fixed rates at the time (today they are actually higher!). It doesn’t matter what index they use, they could use the safest, levelest index in history, the basic nature of the loan and how it works make it a bad loan.
Again, I’m conservative in nature. I want to be debt free and own my house. If you think you can pull out your equity to make money, I’d advise against it, but I would do it in a safe loan program, a fixed rate or even a mid to long term ARM (5-10 years) at least you know what the rate will be and not be tied to a 1 month adjustable. I’d also advise, no matter what the mortgage rate is, that debt will always be there whether you make money with your equity or not, and each month you don’t make money or break even you’re that much more in the hole trying to cover the rate.
Oh yeah, almost forgot. After you see how these loans work why would you stay with it another month, why not refinance now into a fixed rate. A rate that today is about 1% higher than what you could have gotten if you weren’t sold this scam, but still respectable and probably lower than what your 1 month interest only rate is now. The answer, in order for brokers to make yield spread or money on the “back” of the loan they had to sell a prepay with them, the longer the prepay the more they will make. Now you are stuck.
Hope I educated some of you, thanks for the time.
Mike Hels
borrowed from Mike at the Florida Sportsman Forum
http://outdoorsbest.zeroforum.com/zerothread?id=483310
Another thread was derailed talking about these loans and I said I would post a new thread explaining the inner workings of these types of loan to educate potential borrowers and even brokers.
These loans gained their popularity in the last few years with the idea of taking equity out of your home and using that equity to make money and theoretically pay off this loan a lot sooner. Although I’m not a big fan of messing with equity, especially if you are going to risk it trying to make money, but if you feel like this is your gig, be my guest, just know that there are better loan products out there and hopefully you will see why.
As I said, these loans became the “hot loan” to sell within the last four years. The reason I believe they became the hot seller is that the lenders needed something to entice borrowers away from the lowest fixed and short/long term ARM rates in history. How did they do this? They promoted them as “Cash Flow ARMs” with the sell of having a low mortgage payment while you use the difference between available conventional financing to invest or pay off other debts. Below you’ll see why these loans were pushed by the lenders and why they paid brokers 1 to 2% more in yield spread comparable to conventional loans to sell them.
The Option ARM, Cash Flow ARM, or MTA Option ARM are really all the same dog with minor variances. Basically, you finance your property and each month you are sent a mortgage bill with 4 options of payments. The first is the “cash flow option or minimum amount due”, the second an interest only (IO), the third a fixed 15, and lastly a fixed 30 year option. Really every thing revolves around the interest only payment, that is your base mark and that is the interest rate use for the IO, and fixed options. The cash flow/minimum option is actually based on a very low rate, usually in the 1% to 2% range. Now let me go over how the payments work.
Interest Only- Like I said, everything revolves around this payment. You will be given an index for which a margin is added to get you interest rate. Usually the index is the MTA, COFI, 1 Month Libor, etc. and when added to the margin is usually equal or, depending on your margin, higher than the going fixed 30 year conventional mortgage rate. If you choose to make this payment nothing happens, you pay the interest for borrowing the money, nothing more nothing less. If you borrow $100,000 and make the IO payment for 30 years you will still owe $100,000. Now the catcher and this is why these loans were sold at the lowest fixed rates in history, is this rate can change every month, based on what the index has done. So if you signed up for this loan 3 years ago, your rate has gone up at least a percentage or two. Basically it is a 1 month ARM loan.
15 or 30 Year Fixed Option- This option is really a misnomer, it is actually a 15 or 30 amortization option. The same 1 month adjustable rate as calculated above is plugged in and using either a 15 or 30 year amortization, your payment is calculated. Now, this payment will have both interest and principal reduction within the payment, but the payment is calculated as if it were the first payment of the whole loan every month, meaning you are always making 1 out of 360 (30 yr) or 180 (15yr) payments, and as everyone knows the first payments on either fixed rate loans are interest stacked. Again, just to clarify, the rate that is used to calculate the 15 or 30 year fixed option is actually the interest only rate as calculate above, which, once again, can adjust every month. It is not a fixed rate, but a fixed amortization. Think of it as that old trick of walking half the distance to a wall each turn, you will never reach the wall no matter how many turns you take. The same thing is happening here, but instead of going half way you are only going 1 step out of 360 to the wall (payoff of the loan).
Cash Flow/Minimum Payment- If the above isn’t enough to drive you away from these loans, this part will do it. Once again these loans were sold as Cash Flow mortgages, make the minimum payment and invest the difference, you’ll be rich!! Well if you choose this option this is the reality. The difference between the minimum payment and the IO payment gets ADDED to the principal you owe, which is called negative amortization. In reality it may not seem like a lot each month, but you have to remember the same compounding interest principals that apply when you pay a little each month on top of your generic 30 year fixed rate (1/12 of the scheduled payment amount) will cut about 7 to 10 years off of your mortgage. Now think of that in reverse, a couple of years of that and you could owe a lot more that you originally borrowed.
Now don’t worry, the lender has triggers in place that if you get upside down more than 15 or 20% they will recast the loan using the new balance (ie higher payment across the board). Now not only are you paying interest, but you are paying interest on interest you neglected to pay using the cash flow amount and owe 15 or 20% more than originally borrowed. Mind boggling. To cap off the salt in the wound, the lender will sell you a fixed option on the teaser cash flow rate, which is great….for the lender. They don’t want that rate to go up, they want as much spread tacked onto the principal as they can, ending the teaser rate and it going to say 5% will just lessen the interest they can charge interest on again. So yes, a 5 year fixed option sounds great, in reality the lender is handing you a bigger shovel.
These loans were pure genius for the lenders. They took borrowers that would have locked in a low rate (remember they were the lowest in history) into basically a 1 month adjustable rate mortgage, with the potential of negative amortization and remember the rates they offered for this 1 month arm were basically the same as fixed rates at the time (today they are actually higher!). It doesn’t matter what index they use, they could use the safest, levelest index in history, the basic nature of the loan and how it works make it a bad loan.
Again, I’m conservative in nature. I want to be debt free and own my house. If you think you can pull out your equity to make money, I’d advise against it, but I would do it in a safe loan program, a fixed rate or even a mid to long term ARM (5-10 years) at least you know what the rate will be and not be tied to a 1 month adjustable. I’d also advise, no matter what the mortgage rate is, that debt will always be there whether you make money with your equity or not, and each month you don’t make money or break even you’re that much more in the hole trying to cover the rate.
Oh yeah, almost forgot. After you see how these loans work why would you stay with it another month, why not refinance now into a fixed rate. A rate that today is about 1% higher than what you could have gotten if you weren’t sold this scam, but still respectable and probably lower than what your 1 month interest only rate is now. The answer, in order for brokers to make yield spread or money on the “back” of the loan they had to sell a prepay with them, the longer the prepay the more they will make. Now you are stuck.
Hope I educated some of you, thanks for the time.
Mike Hels
borrowed from Mike at the Florida Sportsman Forum
http://outdoorsbest.zeroforum.com/zerothread?id=483310