Don't Fall for the Option-Payment Mortgage Trap

Payment Options

While there are many different option-payment loan products out there, a typical one will have the following payment choices:

• Fully amortized loan payment: This is a regular amortizing loan payment. You pay all the interest for the month, and a portion of the principal. If you made this payment each month, your loan would pay off in 30 years.
• Interest only: You pay all of the interest due for the month, and your loan balance is unchanged.
• Minimum payment: You pay less than the interest due for the month. The lender then adds the unpaid interest to your principal balance. This is called negative amortization. The minimum payment is based on the introductory "teaser" rate, as low as 1%. After a certain period, the minimum payment rate will increase but will still be lower than the loan's real interest rate.

Some lenders offer only fixed-rate option-payment mortgages. Others offer adjustable-rate option mortgages as well, including Countrywide Home Loans, a unit of Countrywide Financial (CFC Quote), Washington Mutual (WM Quote) and Wachovia(WB Quote). Wells Fargo (WFC Quote) also offers an option payment mortgage that is less risky, in that none of the payment options will result in negative amortization.

Negative Amortization

If you have an option-payment mortgage and pay the lowest amount allowed, you will be paying less than the interest that actually accrued for the month. Then, like a loan shark, the lender will add the unpaid interest to the loan principal balance. If you continue making the lowest option payment, the growth of your loan balance will accelerate, since you'll accrue more unpaid interest each month.

Here's an example of what can happen, using our $200,000 mortgage, with interest accruing at 6.00%. Let's assume that you have the same three options described above, with the lowest option payment being based on a rate of 2.00%.

If you make the highest loan payment, your loan amortizes, and the balance goes down. If you make the interest-only payment, the loan balance is unchanged. Below is what happens if you make the lowest option payment each month. Notice how, unlike the previous table -- and contrary to common sense -- the balance of the loan actually increases.

Payment Number (monthly)	Interest Accrued	Option Payment	Unpaid Interest	Loan Balance
1	$1,000.00	$333.33	$666.67	$200,666.67
2	$1,003.33	$334.44	$668.89	$201,665.56
3	$1,006.68	$335.56	$671.12	$202,006.67
60	$1,216.94	$405.65	$811.29	$244,199.32
Source: TheStreet.com Ratings

Isn't this lovely? After only three months of making the lowest option payment, your loan balance has grown by more than $2,000. After 60 payments, you've managed to add nearly $44,000 to what you owe, although at this point most option loan agreements would require that the payments be completely reset to stop the bleeding.