Option ARM - Understanding the Minimum Payment Option

The Minimum Payment is the smallest amount of interest and, if applicable, principal, that you must pay each month. The Minimum Payment may not be enough to pay all of the interest charged on your loan for the previous month and it may not pay down any of the principal balance. If you just make the Minimum Payment, the unpaid interest will be “deferred,” that is, it will be added to the principal balance you owe. This is called “negative amortization,” and it means that the amount you owe increases and you will be charged additional interest at the rate of your loan on the new, larger principal balance.

Basics of Option 1:

The Minimum Payment

1. Your Minimum Payment usually stays the same for 12 months at a time, unless your loan needs to be recast (see #5 below).
2. The Minimum Payment on your loan, which is fixed for your first 12 monthly payments, is initially based on the amount you borrow, the term you select for your loan and the interest rate (the “start rate”) specified in your commitment letter.
3. Every 12 months your Minimum Payment can change. It also can change if your loan needs to be recast.
4. In most years, your Minimum Payment can only increase or decrease by 7.5% per year from the amount of your previous year’s Minimum Payment.
5. Every fifth year, or if your unpaid principal balance increases to more than 125% (110% in New York) of the amount you originally borrowed, your loan is “recast”, or recalculated, to keep it on schedule. At the time your loan is recast your Minimum Payment can increase or decrease by more than 7.5%.
6. When you make the Minimum Payment, you may not be paying all the interest charged on your loan for the previous month. The interest you don’t pay is called “deferred interest” and is added to the total amount you owe.
7. While your Minimum Payment usually stays the same for 12 months at a time, your actual interest rate will change monthly (after the end of your introductory period when your “start rate” is in effect). This means that after your introductory period, your monthly payment may not be enough to pay all of the interest charged for the previous month.

How the Minimum Payment Changes

Typically, your Minimum Payment will increase each year for the first few years you have an Option ARM. This is because the first year’s Minimum Payment is calculated using your beginning interest rate (“start rate”), which is usually lower than the Fully Indexed Rate (the index value plus the margin) that applies to your loan after the end of the introductory period.

In most years, your Minimum Payment can only change up or down by 7.5% per year, because of the 7.5% “Payment Change Cap.”

There are two circumstances when your Minimum Payment can change by more than 7.5%:

• After every fifth year
• If, because of deferred interest, the unpaid principal balance you owe increases to more than 125% (110% in New York) of the amount you originally borrowed

In these situations, your loan is recalculated (“recast”) based on the amount you owe at the time. Recasting your loan keeps you on the original schedule for paying it off. When your loan is recast, for example after five years of 60 months, your Minimum Payment can increase or decrease by more than 7.5%.

When your loan is recast, the calculation is based on:

• How much you still owe (the “outstanding principal balance”)
• How much time is left on your loan (the “remaining term”)
• The interest rate (the “Fully Indexed Rate,” which is the index value plus the margin for your loan

After the recast, the Payment Change Cap goes back into effect – from that point on, your Minimum Payment can only go up or down by 7.5% per year until the next time your loan is recast.

Even when your loan is recast the Lifetime Interest Rate Cap stays in effect. The Lifetime Interest Rate Cap is the maximum level to which your interest rate can rise, and is set at the beginning of your loan.

The Minimum Payment and Deferred Interest

Before you make the Minimum Payment, it’s important to understand deferred interest. Every month, your home loan is charged interest, based on the remaining principal balance and the applicable interest rate.

With the Option ARM, one of your payment options is an “Interest Only” Payment, which covers the amount of interest due that month. When the Minimum Payment is less than the Interest Only Payment, the Minimum Payment will not be enough to pay all of the interest charged on your loan for the previous month and it will not pay down any of the principal balance. If you just make the Minimum Payment, the unpaid interest will be “deferred,” that is, it will be added to the principal balance you owe. This is called “negative amortization,” and it means that the amount you owe increases and you will be charged additional interest at the rate of your loan on the new, larger principal balance.

Any time you defer interest, your loan statement will track and display it each month as “unpaid interest.” While deferred interest is added to your overall loan balance, you also can choose at any time to pay the amount down more quickly.

How the Minimum Payment May Change in the First Five Years

The two examples below show how the Minimum Payment may change in the first five years, as a result of a full 7.5% (shown as 1.075 in the example below) maximum annual payment increases. Remember, if the index is dropping, the maximum annual payment decrease is also capped at 7.5% of the Minimum Payment for the previous year. Examples are for loans of $180,000 and $460,000 with a 30-year term and start rate of 1.25%.

EXAMPLES

These examples show what would happen if you had one of these loans and made only the Minimum Payment ever month. If interest rates are rising, making only the Minimum Payment could lead to substantial deferred interest. This could cause your loan to be recast in the first five years, at which point your Minimum Payment could rise more than 7.5%, or could lead to a significant change in your Minimum Payment when your loan is automatically recast after five years of monthly payments.

This fact sheet descries how the Minimum Payment works and how is can change. See the Option ARM Payment Options Fact Sheet for more information on other payment options.

Consolidate Your Debt with a New Purchase Mortgage

Some home buyers try to kill two birds with one stone by consolidating their debts in a new purchase mortgage. Usually this is not a good idea, as in the case illustrated below from our fictitious Mr. Jones.

“I have $30,000 in cash for a down payment on the $300,000 house I am purchasing. I also have a $15,000 of credit card debt at 12% that I would lover to get rid of. The loan officer says I can roll in into a new $285,000 30-year mortgage at 6%. This cuts the rate on my credit card debt in half and makes it deductible. Further, my total monthly payment would be only $1891, compares to $2,051 if I didn’t consolidate and took a $270,000 loan. Is there any reason I shouldn’t consolidate?” – Sincerely, Mr. Jones

Yes, appearances to the contrary notwithstanding, this consolidation will only make Mr. Jones poorer.

True, the rte on the mortgage is well below the rate on his credit card debt, and the mortgage inters is tax deductible as well. However, if Mr. Jones increases the size of his loan from $270,000 to $285,000, he will increase either the mortgage insurance premium or the interest rate on the purchase mortgage. It take only ¼%rate increase on the $285,000 to offset the savings from a 6% rate reduction (including the shift to deductibility) on $15,000 of credit card debt. Consolidation would also reduce Mr. Jones’ total monthly payment, but that is mainly because he would be paying down his debt more slowly. If he consolidates, he will owe $260,484 at the end of 6 years, which may be his best guess as to how long he will be in his new house. If he doesn’t consolidate, he will owe only $246,774.

These numbers and the others cited below are drawn from a simple calculator used to determine Mr. Jone’s total costs over 6 years if he:
a. Doesn’t consolidate, which means he takes the first mortgage for $270,000 and leaves the non-mortgage debt as is;
b. Consolidates in the first mortgage, which means that he takes the first mortgage for $285,000 and pays off the non-mortgage debt; and
c. Consolidates in a second mortgage, which means that he takes out the first mortgage for $270,000 to buy the house, and afterwards he takes a second mortgage for $15,000 to pay off the non-mortgage debt.