Pick-a-Payment Loans: The Basics
Pick-a-payment mortgage loans are adjustable rate mortgages. These loans give homeowners four payment options: minimum payments, which don’t cover the total interest payment; interest-only payments, which are regular payments with interest and some of the principal and is typically designed to pay the mortgage off in 30 years; or larger than normal payment that allow the homeowner to pay the mortgage off in 15 years.
What It Means
Regular and larger payments are straightforward because they put money toward the principal and the interest every month until the mortgage is paid. The other two options involve catching up later. An interest-only payment allows homeowners to pay only the interest on the loan for a set time, then they must begin making larger payments on the principal and interest in order to catch up. When choosing the minimum payment option, the payments won’t cover the entire cost of interest. These payments are designed to last for 12 months or 60 months. Then, the homeowner will be required to begin paying on average 63 percent more than their regular mortgage payments. Also, because minimum payments do not pay the entire interest on the loan, the balance will continue to escalate. If the balance reaches 110 to 125 percent of the starting principal, the homeowner will have to start making the larger payments, even if the five-year mark has not been reached. This option is used by homeowners who expect an income increase that time. When choosing the 12-month minimum payment, the homeowner will pay 1 percent of the mortgage payment for the first year. When choosing the five-year minimum plan, the payment will be 1.9 percent of the mortgage payment every month for 60 months.
The principal advantage of the pick-a-payment plan is to use one’s cash at one’s discretion and to control tax deductions for the first year or five years. Homeowners who choose pick-a-payment plans and employ the minimum payment option may want to put their money towards other investments, such as additional properties they need to sell to make full payments on the newest one.
Minimum payments can leave homeowners in financial stress if they have financial problems when they are supposed to be increasing your payments. Saving money each month or ensuring one’s investment cash is readily available can help homeowners prevent this from happening.
Option ARM Loans
Option ARM loans are mortgages that allow homeowners to choose the amount of their payment. The tend to be considered high-risk loans.
Option ARM loans provide both flexibility when choosing payment and an adjustable rate or ARM. These loans may allow a homeowner to make any of the following payments:
- A low minimum payment
- A fully amortizing payment (for a 15, 30, or 40-year amortization schedule, for example)
- Interest only
Based on a homeowner’s budget for each month, they are allowed to choose the payment they can afford.
Although the flexibility can be a benefit, it comes with risks. Firstly, a homeowner won’t build equity unless they increase payments. Smaller payments may mean the homeowner will owe more on their house at the end of the month than at the beginning. The option ARM loan is effectively a negative amortization loan.
Also, reduced payments aren’t permanent. Sooner or later the bank will demand that the loan be paid off. The bank can also recast the loan, for example every 5 years, and/or when the homeowner owes too much on the property (110% or 120%, for example) due to negative amortization. When recasting, the loan is put on track to fully amortize over its remaining life, and minimum payments will increase sharply, which can be a problem if the homeowner can’t afford it.
How to Use Option ARM Loans
If a homeowner’s only possibility of acquiring a loan is an option ARM loan, they should only be taken on for temporary flexibility, not long-term savings.
Rate Spread Home Loans
Rate-spread home loans have an annual percentage rate (APR) that exceeds the “average prime offer rate” at the time the rate was set by at least 1.5% for first-lien mortgages, or 3.5% for subordinate mortgages. The average prime offer rate is a rate published by the Federal Reserve Board based on average rates provided to consumers for low-risk transactions.
The APR exceeds the “conventional mortgage rate” at the time the rate was set by at least 1.75% for first-lien mortgages, or 3.75% for subordinate mortgages. The conventional mortgage rate is published by the Federal Reserve System’s Board of Governors. The APR surpasses the yield on U.S. Treasury securities with comparable periods of maturity by at least 3% for first-lien mortgages, or 5% for subordinate mortgages.
Also, the mortgage loan principal must be within the corresponding loan size limit for a single-family dwelling, set by Fannie Mae, and the property must be the borrower’s principal dwelling. Loans for equity lines of credit, construction loans, reverse mortgages, and bridge loans with terms of 12 months or less do not qualify.
The following protections apply to rate-spread home loans:
- The homeowner’s ability to repay must be considered in making the loan
- Prepayment penalties are prohibited
If the bank violates these provisions, they can be legal liable if either of the following are established:
- That within 90 days of the closing and before any action was instituted against the bank, the bank informed the homeowner of the failure, made restitution, and agreed to change the loan terms.
- That the compliance failure was the result of an unintentional error that occurred despite reasonable procedures for avoiding such errors; and within 120 days after discovering the error and prior to the institution of any action against the bank, the bank informed the homeowner, made restitution, and agreed to change the loan terms.
The mortgage broker who brokered a non-complying rate-spread loan is also liable with the bank.
According to the Wiley Online Library, “The most widely used public database about mortgages in the US, the Home Mortgage Disclosure Act (HMDA) data, was revised in 2002 to include information on the cost of credit. The banking industry fought efforts to add new informa- tion, and as a compromise the Federal Reserve only required lenders to disclose the cost of credit for the highest-cost loans – mortgages with a spread of more than three percentage points over the yield on US Treasury Securities of comparable yield for first-lien mortgages, and five points for subordinate liens. (First-lien lenders are first in line for repayment in the event of bankruptcy.) For loans made after October 1, 2009, these triggers were reduced to 1.5 percent and 3 percent, respectively, and the benchmark was re-defined to compare loan costs to the average prime mortgage offer rate.”