It seems that wherever you encounter a mortgage advertisement, be it a TV, radio, Internet, billboard, or newspaper ad, there is mention of a curiously low payment loan program (sometimes, but not always as it should be, accompanied by a disclaimer). Sometimes the ad will specify that the rate is 1%, or in that range, sometimes it will just focus on loan amounts and payments. I suppose the minds behind these ad campaigns are betting that they can arouse concern among borrowers that their rate/payments are inordinately high, so the average Joe or Jane will call in saying, "how can I get me one of them?".

Well folks, as we have all heard before, there is no free lunch, and if it seems to good to be true it probably is. This loan product is known as the Option ARM (adjustable rate mortgage), pick-a-pay ARM, and also goes by a variety of other names depending on the lender. Regardless of the name, let's look at how this product works, and determine if, when, and for whom it is an appropriate form of financing.

The Option Arm typically has four monthly payment options:

1)The "start" rate offers the minimum payment, which is otherwise known within the industry as the "teaser" rate.

2)The "interest only" payment option offers a way to make a low payment, but the principal is not being paid down as in a fully amortized loan.

3)30-year amortized payment. This is based on the fully indexed rate.

4)15-year amortized payment. Also based on the fully indexed rate, this option would be the highest payment option in any given month. This choice has the greatest impact on paying down the principal on your loan, which is necessary at some point.

With payment option #1, which is the payment the ads highlight, a borrower may experience "negative amortization", which means the principal balance increases. If a borrower goes into the loan expecting that the "teaser" rate and payment is all that is required, they will be in for a rude awakening when they come to understand the actual terms of this loan program. I am not saying that this loan program does not have its time and place. Allow me to give you an example of an individual for whom the Option ARM may be appropriate. In the South Florida region where I am currently located, many businesses are seasonal and tend to be much busier during the main tourist season. Let's say you own a restaurant that is very busy for half the year, and business drops off significantly during the slow months. The Option ARM may be a good choice for you because during the months when cash-flow and liquidity may be low you can make the minimum or interest only payment. Then when business is swift you can choose the higher payment options to make sure you avoid negative amortization. But is this loan product suitable for Grandma and her fixed income? Probably not. Nonetheless, many lenders and brokers constantly tout these products and lots of mortgage companies urge their employees to push this loan program.

Why? The way lenders pay commission on the Option ARM. Very often, advertisers and loan representatives (LR) will try to direct your focus to the low payment, and not on the true cost of your loan. Your true rate is based on one of several indexes plus the "margin" attached to your loan. This is known as the "fully indexed rate". The index is typically the LIBOR, COSI, CODI, COFI, MTA, etc. .... and generally is subject to change on a monthly basis. The index value will fluctuate over time. The other component of the "fully indexed rate" is the margin. What most borrowers don't know, and most LR's don't offer to explain, is how the margin works.

Secret: The higher the margin is that is attached to your loan, the higher is the commission that the lender pays to the LR in the form of a Yield Spread Premium (YSP). Many LR's love to sell this product because borrowers, who often are not aware of the "margin" and how it impacts their loan, don't ask about it. LR's routinely slap on the highest available margin made available by the lender, and generate a 3% YSP ( percentage of the loan amount ) without having to bother explaining it to the borrower, who is focused on that "teaser" rate and payment. This is also how LR's manage to get you that miracle loan that features the low payment, no appraisal fee, and no closing costs. And consumers love to bite on the bait, which is why big budget advertisers focus on enticing people with the low (minimum) payment feature.

The bottom line is that your fully indexed rate consists of an index, which moves, and the margin, which remains the same. The higher the margin, the higher the fully indexed rate. See why LR's love this product? I'm not going to get any holiday cards from LR's for shedding light on this subject, but my responsibility is to you the consumer, and not to unethical practitioners who hurt their customer and mar the reputation of those of us in the lending industry who operate with integrity.