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.



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.


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 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



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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.

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.



You may get whacked with a sharp increase in your monthly payment.

Option-payment mortgages allow negative amortization only for a specified period, typically five years, after which the loan payment will "recast," or be recalculated with full amortization.

For a borrower who has grown accustomed to making the lowest option-payment each month, this can lead to payment shock, as there is a sharp increase in the required payment. The new payment will be based on the increased loan balance and the interest rate, and the borrower will now have a traditional principal and interest loan payment. This new payment may well be more than the borrower could have afforded when the loan was originated.


Your best-laid plans could lead to foreclosure.

During the residential real estate boom, lenders and mortgage brokers would often push option-payment mortgages using the same argument they used to push ARMs. The pitch was that if you were only planning to own the house for a few years, this would be the best deal for you because you'd have lower payments now. Besides, you could always refinance to a fixed-rate or simply sell the property for a profit and walk away.

The expectation was that the borrower would build equity regardless of the loan features, because home prices would continue rising sharply. The triple whammy of low (or no) down payments, negative amortization and payment shock quickly led to financial disaster for many borrowers. In today's environment, many people who used option mortgages with low down payments to buy homes will find it impossible to sell their houses for a profit. With little or no equity in their homes, it may also be quite difficult to refinance and avoid foreclosure.

Since you really can't predict everything that will happen after you buy a home or refinance, you should resist the option-payment temptation. You're going to have to pay for the home, and hiding from doing so by using option payments is the surest way to experience payment shock and foreclosure. Your mortgage should be a simple instrument that helps you pay for a home. Anything as complicated as an option-payment mortgage spells doom.

Philip van Doorn joined TSC Ratings as a banking analyst in February 2007. He has a varied background, with a B.S. degree in business administration from Long Island University. He previously worked as a loan operations officer with Riverside National Bank in Fort Pierce, Fla. Before that he was a credit analyst, monitoring banks and thrifts at the Federal Home Loan Bank of New York.