- The Washington Times - Wednesday, March 29, 2006

Q:I am looking into moving up to a home that’s for sale for $1,100,000. We

should net about $400,000 from the sale of our current residence and plan on

using the proceeds for a down payment.

The problem is that the payment on a $700,000 loan is unaffordable to us.

We have been looking at the Option adjustable rate mortgage (ARM) programs and think this might be the way to go. We understand the whole concept of negative amortization and are comfortable with it because our income is going to continue to rise and this is a house we plan on staying in for a long time.

Do you think an Option ARM would be a good move for us?

A: The exploding popularity of alternative mortgage programs such as interest-only and negative amortization loans has received a lot of unfavorable media attention in the last couple of years. My position on these programs has never changed: More mortgage choice is a good thing for the consumer. But with such a large and complex menu, a clear understanding of each product is necessary to make the right decision.

Option ARMs, FlexPay ARMs or Cash Flow ARMs — call them whatever you like — all do the same thing. They allow monthly payments to be less than the interest charged for that month, increasing the balance. This is negative amortization, or “neg am.”

A financially responsible person might consider such a mortgage to be dangerous. That’s not always the case. If a neg-am loan is fully understood and taken out with a solid plan, it can certainly be the right product for some folks. But if a homeowner takes out a neg-am loan and doesn’t understand it, it can be very dangerous.

Consider this: A few years back a couple called me to refinance their mortgage. It turns out that they had been making the minimum payment on an Option ARM for five years, accruing $600 per month in negative amortization. When they called me, they had absolutely no idea that their mortgage balance was $36,000 more than when they first took out the loan.

Whether this can be blamed on the loan officer or the borrower’s own lack of effort to understand what kind of mortgage they took out is anyone’s guess. The point is that clear understanding and responsible use is essential.

You use gasoline to power your car, not to start a fire in your fireplace.

Let’s look at your situation. I can certainly see that, despite the increase in short-term interest rates, an Option ARM might suit your objectives. A $400,000 down payment, a steady increase in income, a full and complete understanding of the product, a desire for an affordable monthly payment, and a strong desire to purchase the expensive house sounds to me like an Option ARM scenario.

One might argue that you shouldn’t be buying a house that’s priced out of your range or affordability when using conventional financing. While such an argument certainly bears merit, it’s irrelevant if you are able to purchase the house you want and finance it responsibly.

I rarely recommend neg-am loans to clients, but let’s apply some numbers to your situation.

I see that we have an Option ARM with a current fully indexed interest rate of 6.50 percent. The interest charged on a $700,000 loan is $3,792 per month. But the minimum payment is based upon an amortized rate of only 1.25 percent, which equals $2,333 per month. The difference of $1,459 is added to the balance each month. Is this a bad thing? Well, it depends.

Since you are making a $400,000 down payment, there’s not a whole lot of danger of becoming “upside down,” or the balance exceeding your home’s value. In fact, a monthly negative amortization of $1,459 amounts to an increase of $17,508 in one year. While this number might appear big, it’s only a 2.50 percent increase in the mortgage balance.

Since most Option ARMs carry rates that can adjust monthly, it’s very important to understand that if the rate increases, so will the negative amortization.

Buying real estate carries some risk, like all other investments, but history has proven that over time, your own home is one of the best investments you can have.

An Option ARM certainly carries more inherent risk than a 30-year fixed-rate loan, but that doesn’t mean the product is not appropriate for certain situations.

It seems to me that yours is one that might be appropriate.

My advice? Understand the details completely before jumping in.

Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail ([email protected]pmcmortgage.com).

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