Is a Flexible ARM For You?

With most mortgages, your payment is the same every month. But what if your paycheck isn't so regular? Would you like to be able to vary your mortgage payment depending on your cash flow? An option ARM - also called a flex-ARM or pick-a-payment loan - allows you to do just that. An option ARM is an adjustable-rate mortgage with a twist. You don't pay a set amount each month. Instead, the lender sends a monthly statement with up to four payment options. You simply choose the amount you want to pay that month and then submit your payment.

THE UPSIDES: Homeowners can make low payments when money is tight and pay more when they can afford it. The other selling point -- an extremely low minimum payment for the first year - is also its biggest risk factor. Homeowners could pay as little as 1 or 2 percent, with payments that increase as much as 7.5 percent per year. Another upside for a narrow group of homeowners is the option to make interest-only payments. Mortgage brokers say this can be a good strategy for those who plan to be in their homes for a short period, say five to seven years, or whose income might be going up in the near future.

THE DOWNSIDES: Payment shock when the interest rate on your adjustable rate mortgage increases, which can double or triple the initial payment. Because the initial payment is so low, borrowers are tempted to purchase more home than they ultimately can afford. If you pay only the minimum amount, which may not cover the interest on the loan, you can wind up in a state of "negative amortization" with unpaid principal and interest gets added to the balance of the loan, leaving you with a house that's worth less than your mortgage. Every five or 10 years (or sooner if you hit a negative amortization maximum) the bank will "recast" your loan so that it can be paid off within the remaining term either at the current interest rate or a rate spelled out in your loan agreement.

The loan carries and adjustable interest rate, and this rate can adjust as often as every month. If the borrower is paying only the minimum payment, then he or she isn't even paying enough to cover that month's interest on the loan. What happens then? The unpaid interest that has accrued is added to the loan principal. The principal can actually grow larger, and as interest due is calculated on the loan principal, the interest due will increase, as well. Interest rates are currently near all-time lows and are sure to increase.