- The Washington Times - Thursday, February 3, 2005

In the past year or so, I think one of the most popular subjects — according to the e-mail I receive — is the emergence of low-payment adjustable-rate mortgages (ARMs). I’ve written extensively about monthly ARMs, interest-only programs and negative amortization. There’s a lot of misunderstanding and misinformation about these products, so I’d like to devote some space to setting the record straight.

First, lenders nationwide have responded to consumer demand for affordable mortgage loans. Adjustable-rate mortgages carry a lower initial interest rate, resulting in a lower payment.

In exchange for the lower rate, the lender transfers interest-rate risk to the borrower. Anyone who takes out an adjustable-rate mortgage must understand that his rate (and payment) could rise at some point.

Second, there are dozens of mortgage programs that allow the borrower to pay only interest for a specified period. A traditional mortgage is amortized over time, usually 15 or 30 years. This means that the minimum monthly payment will always include a principal payment that is enough to bring the balance down to zero by the end of the term.

Interest-only loans don’t curtail the principal every month, resulting in a much lower payment.

Third, there are myriad mortgage programs that allow negative amortization. The politically correct term is “deferred interest,” but it means that the minimum payment required by the lender isn’t enough to cover the interest charged on the loan.

When that happens, the mortgage balance rises each month by the amount of interest that wasn’t paid.

The result? A really low payment but a rising debt load.

When you think about it, it’s no surprise that these products have gained popularity. Short-term interest rates, which affect adjustable-rate mortgages, fell through the floor after September 11, making ARMs more attractive. At the same time, housing prices skyrocketed, making homeownership more difficult to afford.

Consumers turned to low-rate, low-payment ARMs in order to afford the houses they wanted.

There are lots of catchy names for these products. Here are a few: “Option ARM,” “Choice Pay,” “Personally Tailored Mortgage,” the “Mortgage Stretch,” “Cash Flow ARM,” “Flex Pay” and “Advantage ARM.” The list goes on and on.

All of these products allow the borrower to choose how he wants to pay off the loan every month.

In most cases, the lender will send a statement with four payment options. The first choice is typically the “minimum payment,” which results in negative amortization. The second option allows you to pay only the interest charged, so your principal balance neither increases nor decreases.

The third and fourth options are payments based upon a 30- and 15-year amortization, respectively.

Some critics charge that these loan programs are irresponsible because they expose the borrower to the possibility of higher interest rates and increased debt in the future.

This is certainly true, but as with anything else, the price of freedom is responsibility.

A flexible payment plan for a mortgage is a fine thing as long as it’s used responsibly.

Having said that, there are some lenders who deserve some sharp criticism for the methods they use in marketing these programs. It concerns the difference between “interest rate” and “payment rate,” and it’s the subject of next week’s column.

Henry Savage is president of PMC Mortgage in Alexandria. Contact him by e-mail (henrysavage

@pmcmortgage.com).


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