The general consensus about the riskiness of Option Pay mortgage loans is that they are high risk; high risk to both the borrower and the lender. To add even more risk to the loans, consumers and loan officers not only have to understand initial and lifetime caps, various indicies and margins, but also teaser rates, prepayment penalties, negative amortization caps, and moving indices. What we end up with is a risky, popular, and often misunderstood mortgage loan.

Known as an Option Pay mortgage, it's an adjustable-rate mortgage that typically allows borrowers to choose one of four different payments each month. From smallest to largest, they are: a minimum monthly payment, an interest-only payment, full principal and interest amortized over 30 years, or full principal and interest over 15 years. Those who choose the interest only payment pay no principal each month, but they pay the full amount of interest due. Those who choose the minimum payment pay no principal and less interest than what accrued on the loan. The unpaid interest is added to the loan balance, resulting in what is known as negative amortization.

While accounting for less than 5% of all loans in 2004, Option Pay ARMs could account for as much 20% - 25% in high cost housing markets specifically those located on the East or West coast. These loans are often being used to buy more house than a borrower could otherwise afford or to offset negative cash flow in a second home or investment property. Used in this fashion, the biggest risk of the mortgage loan is increasing monthly payments. The increasing payments can be caused by several events: rising interest rates, expiration of a teaser rate, and a rising loan balance.

Since the product is often used in high cost housing markets and for investment properties, one could assume that the home buyer understands the overall risk of their housing purchase decision and the risk inherent in the Option Pay ARM. It is up to each individual to understand their acceptable risk level and act accordingly.

Now for the rest of the story....

Many mortgage companies use the introductory low rate as a marketing tactic offering 1.0% or 1.75% mortgage loans with very low reported Annual Percentage Rates (APR) through direct mail, newspapers, and internet advertising. The lower rate, lower payment, and teaser rate are very attractive and borrowers often complete a mortgage application before completely understanding the terms and conditions of the mortgage loan program. By the time the borrower figures out what is going on, they are well into the mortgage application process and often switch to a less risky program with the same lender.

If an Option Pay ARM is not right for you, something will not feel right when you get more information from the lender. If you walk down that path, please make sure you fully understand the risks and financial impacts that you may encounter. If an Option Pay ARM is truly right for you, you will recognize and be financially capable of assuming the risk involved in the ARM and will use the lower payment options for your financial benefit.

And please do yourself a favor now. If youre drawn to Option Pay ARMs, first learn more about Fixed Period ARMs such as the 5/1 which is fixed for 5 Years and then converts to an ARM program. You will enjoy a lower rate for 5 years and the program offers Interest Only and 100% LTV options with no prepayment penalties.