How about a mortgage with an interest rate as low as one or two percent? Wow! The payment on an adjustable rate mortgage may sound great but as the old adage goes, if it sounds too good to be true, it probably is.

At the time this article was written, the Federal Government borrowed money at 4.64% APY for a one month term, so can an individual homeowner borrower money at a rate lower than our government? The simple answer is no. Can this still be a good loan? Yes, for a select few who understand how it works. The remainder of this article will cover the basic questions you should ask when considering the negatively amortizing loan commonly referred to as an Option ARM.

First let’s define some important terms.

Payment Rate: The percentage rate used to calculate your minimum monthly payment. It is typically the artificially low rate of 1 to 3% (or any rate equal to or lower than the One Year T-Bill rate: currently 5.23%) that is being advertised by your lender. Remember that the government borrows money at what is called the “risk free” rate and everyone else pays a higher rate that reflects a “risk premium”.

Index: The particular statistical indicator tied to your loan. This value may rise or fall over time and this may in turn raise or lower the interest rate on your loan. Some examples of indexes for the Option ARM are the Monthly Treasury Average (MTA) or the Cost of Funds Index (COFI).

Index Value: This is the numeric value of your index today. You can check the value of the index in the Wall Street Journal or other similar publication at any time on your own.

Margin: This is a numeric value that does not change over time. It is important to note that your margin is negotiable. A big mistake that borrowers make in obtaining an Option ARM is in failing to negotiate the margin.

Fully Indexed Rate: Now we are finally getting to the real interest rate you will be paying on your loan. The index value plus the margin equals your fully indexed rate. This rate may be 7%, 8% or higher.

Amortization Period: The actual number of years it will take to pay a loan in full.

Negative Amortization: The increase in mortgage debt resulting from the difference between the fully indexed rate and the payment rate (i.e. loan= $300k, payment rate =1%, fully indexed rate = 7%, then at the end of one year NEG AM could = $300k * (7% - 1%) = $18k and your loan at the end of the year = $318k).

These are the basic terms that need to be understood to begin to estimate the risk and rewards of an Option ARM. There are also payment and rate adjustment caps that offer some additional protection for the borrower. The Option ARM is an extreme way of leveraging real estate and managing cash flow. Theoretically, the borrower is making a rate of return higher than the rate of negative amortization. If this is the case then the Option ARM works well for that borrower. Another suitable fit for this loan type is a borrower that will experience a dramatic increase in their income in a few years and the monthly savings are more precious at this present date.

The sad reality is that some lenders market the Option ARM as if that low, low payment rate is the actual interest rate and applicants flock to this type of financing without a true understanding of negative amortization. Even worse is the lack of understanding by many participants in the mortgage industry. Inherent in the Option ARM is the pre-determined limit to the amount of negative amortization permitted. That limit may be anywhere from 10% to 25% of the original loan balance. Regardless of any payment or rate caps, when the negative amortization increases the mortgage balance to that pre-determined threshold then all bets are off. The borrower can no longer pay that low, low payment rate. The borrower will also no longer have the option of paying an interest-only payment. The borrower will then be faced with having to pay a fully amortizing payment at the fully indexed rate. In a worse case scenario, this could result in an almost tripling of the minimum payment required before the end of the second year.