Now over three years into what is being called the credit crisis, few people have not in some capacity heard about the pick a pay arm loan, also known as the pay option arm. However, few people seem to truly understand what they are (or were.... It will be difficult to find one these days) or how they actually work. In this article, I will explain what these loans actually are and whether they are truly as evil as they have been seemingly forever defined.  

You likely heard much of the buzz around these loans associated with a 1% interest rate. 1%? Really? Well, no, not really actually if you define interest rate from a perspective of what you ultimately need to pay back. The pick a pay loan can potentially negatively amortize which means that you may have the option of paying less interest each month than is actually accruing on your loan. That is normally the case, for example, with the ability to pay a payment based on a 1%  rate.  

So what does that mean exactly and what are the payment options someone can actually pick from? Well, there are normally 4. I will explain them next.

Before we get started, the general payment "options" are: 1) the minimum payment 2) the interest only payment 3) the fully amortized payment (30 year payment amortization) 4) the fully amortized payment (15 year payment amortization)

When you get your monthly statement, the very first option is the "minimum payment." this is the minimum payment you need to send to stay on time and compliant with your  mortgage. So, what is the minimum payment? Well, generally it is an arbitrary number set for the specific version of the pay option arm selected. Very often it is 1%, 1.25% or 1.75%. There are different types of pay option arms that all essentially work the same but with different details.  

So, is this interest rate actually your interest rate? No, it is the "payment rate." the interest rate, and therefore the interest itself, will accrue at a different rate. This is where negative amortization can come into play which I'll illustrate shortly. So, yes, you could pay this rate but it may or my not actually over the interest due on the loan.  

Second, your bill will show the interest only option. This is the amount of interest that has actually accrued on the loan. So what rate is it? Well, it adjustable typically and can adjust monthly. Most common is the use of either the COFI index, or the cost of funds index, or the MTA which is the monthly treasury rate adjusted to a common maturity date PLUS a fixed margin.  

Think of it like your credit card.... You may have a rate of prime plus 10 or prime plus 12. This means that your rate will always be 12 plus whatever prime is. If prime is 4% your rate will be 14% or 4% ( the index) plus 10% (the margin). The margin will never change but the index will.  We will use the MTA as an example now.  

Today the MTA is around .18% but it was as high as 8% in the very early 90's. Indexes on this product generally varied between 1.5% and 3.5% depending on the occupant of the property, your credit, the home value vs. loan percentage, and the amount of profit the mortgage company was taking. Let's say for example that you had a 2.25% margin then your rate would actually be 2.25%+.18% or 2.43%. not too bad but keep in mind that the rate could change regularly as the MTA changes. So, your interest will accrue at 2.43% and payment option two would be the interest only accruing at that rate.  

Option three quite simply is the payment necessary to pay the loan in 30 years based on your outstanding balance and the current interest rate used above.

Option four is exactly the same as option three but amortized for 15 years.

Let's look at a 400k loan as an example.

Payment option 1 (1%): $1351 Payment option 2 (int only at 2.43 % today): $810 Payment option 3 (30 year am at 2.43% today): $1644 Payment option 4 (15 year am at 2.43% today): $2786

So let's look at this. Option 1 is the minimum payment. So, in this case, option 2 is actually no an option at all in this case. The borrower must pay the minimum. However, it is less than the 30 year am so if one were to pay only the minimum, AND interest rates never changed, it would take longer than 30 years to py it back. However, that Is the beauty of this. One can make a different payment each month and it will re-amortize the following month. Theoretically, you could pay the minimum of 1351 one month then send the 15 year payment the next month and it will constantly re-amortize options 3 and 4 based on your previous payment. Easy enough right?  

Well, it can be. So what all the fuss and what is negative amortization. Let's say that you have the loan and the MTA climbs to 5%. your rate would then be 7.25% (2.25 margin plus 5). What are the options then?

Payment option 1 (1%): $1351 Payment option 2 (int only at 7.25% today): $2416 Payment option 3 (30 year am at 7.25% today): $2865 Payment option 4 (15 year am at 7.25% today): $3844

In this scenario, the int only option number 2 is over $1000 more than the minimum required payment. So, if you were to pay th minimum payment each month, you would be paying less than the interest accrual at a pace of a bit more than $1000 per month. This is negative amortization. That $1000 just gets added to loan balance causing the balance to go up instead of down.

So, is the product terrible? No, in my opinion not at all. It is actually quite an interesting option with a lot of flexibility. However, the use of it has been terrible in many cases. It should never be used as a tool for people to afford more than they can really afford. That is a recipe for disaster and this did often occur.  

On the contrary, the product should really be used for borrowers that cam easily afford any of the payment options and like the flexibility to create a structured cash flow that meets their needs. Maybe someone is investing the difference between the minimum and the 30 year payment so that they have the money if needed but are putting it to use in other ways. It can also be used by borrowers that get large annual bonuses where they make more than enough money but only get paid once or twice per year. This is perfect because one could pay just the minimum and then catch up the difference once per year, etc. creating the flexibility they need.  

Too often though, it was abused by people wanting to get a second home, or just refinance for a lower payment that really couldn't afford a larger payment other than the minimum payment. That is in issue. For others however, they serve a perfect purpose of creating cash flow for those can afford and manage the loan regardless of payment option or for those that can sustain the interest rate increase possibility without losing the home. This loan is a tool. Like any tool it needs to be used in a proper and responsible manor.