Don't Fall for the Option-Payment Mortgage Trap

Chances are you've seen the TV ads encouraging you to refinance your home with an option-payment mortgage. These commercials emphasize the thousands of dollars you can "save" each year when you pay using the lowest options. Too good to be true? You bet it is.

What those ads don't mention (aside from the split-second flash at the bottom of the screen) is that when you make the smallest allowed mortgage payment, your loan balance actually increases. Here are three reasons to steer clear of option-payment mortgages.

1. Negative amortization is a ticking time bomb.

In the TV ads, the lenders pushing option-payment mortgages state that the lowest payment option will be based on a much lower rate than a regular mortgage. However, they fail to mention that in reality your loan will accrue interest at a much higher rate, and your loan balance will increase as you make those nice low payments. They also fail to mention the inevitable consequences.

Amortization

To understand what's going on here, let's take a step back and look at amortization. For a fixed-rate mortgage, amortization is the payment of interest and principal over the loan term, with the principal balance declining to zero.

While the payments are level, the weighting of the loan payment to interest and principal changes each month. Regular adjustable-rate mortgages amortize as well, with the loan payment being recalculated every time the rate adjusts. Early payments are weighted most heavily toward interest, and later payments toward principal.

Below is an example of a 30-year (360-month) mortgage for $200,000 with a fixed rate of 6.00%. As you can see, over time the balance of the loan dwindles toward zero.

Payment Number (monthly)	Loan Payment	Interest Portion of Payment	Principal Portion of Payment	Loan Balance
1	$1,199.11	$1,000.00	$199.11	$199,800.99
180	$1,199.11	$719.91	$486.20	$142,096.50
359	$1,199.11	$11.88	$1,187.23	$1,189.14
Source: TheStreet.com Ratings