For Los Angeles newlyweds Joseph and Jamie Horton, the deal looked too good to pass up: a mortgage with an initial 1.75% interest rate and payments that wouldn't adjust for five years.
The Hortons figured that with all the money they would save on interest payments, they would be able to pay down a significant chunk of the principal on their loan. So they signed on the dotted line.
But after a month, the actual interest rate on their "option" ARM shot above 8%. They blithely made the minimum payment each month, not realizing, they say, that the low rate they had secured was so fleeting. Within months, thousands of dollars in unpaid interest was added to their loan balance. Ready to bail out, they discovered a second catch: a prepayment penalty that would cost them $18,000 if they refinanced.
"They held a carrot in front of us and told us that this was a great deal," said Joseph, 32, a vascular specialist who has since refinanced into a fixed-rate loan. "In one year, it cost us $83,000. It was just excruciating."
An option adjustable-rate mortgage is a complex type of hybrid mortgage originally designed for a narrow segment of people: sophisticated borrowers with inconsistent incomes. But because an option ARM has such a low initial payment, it became popular during the housing boom, with about $250 billion in option ARMs issued over the last three years. More recently, the loan's appeal has dimmed amid higher short-term interest rates as well as horror stories such as the Hortons'. But the mortgage is still being marketed aggressively.
If you are thinking about taking out an option ARM, here are some important tips:
Know your options
Each month an option ARM gives you a choice of four payment amounts:
* The highest amount, if paid every month, would be enough to pay your loan off in 15 years.
* The next-highest amount is calculated to pay off the loan in 30 years.
* A third option allows you to pay only the interest accruing that month -- and none of the principal.
* The fourth option -- the minimum payment -- is the most tempting and usually the one that's advertised. It is calculated based on a "teaser" interest rate that can be as low as 1% or 2% a year. But after the first month, if you make the minimum payment, not only are you not paying down the loan, you're not even paying all the interest that's accruing. As a result, your total debt is actually increasing.
Understand the teaser
