SANTA CRUZ (November 14, 2009) - The popular 30 year fixed rate loan requires the same minimum payment each month for 360 months, at which time the loan balance will have been paid in full. This process of paying off some principal each month is called amortization. A $400,000, 30 year fixed rate mortgage at 4.75 percent requires a payment of $2087 each month of which $1583 is interest and $504 goes towards paying off the mortgage. This mix changes a little each month due to the fact that the loan balance is being chipped away monthly.

Many years ago the mortgage industry came up with a couple of brilliant products when it created loans that allow the borrower the flexibility to determine the monthly payment. Both concepts have caused confusion for borrowers as well as a topic for the media to use to pick on the mortgage industry.

The ‘Option ARM’, which had an interest rate that adjusted each month, but had an initial below-market interest rate (which in some cases only lasted one month) as low as 1 percent and provided borrowers with four mortgage payment options: a minimum payment based on the initial rate that was not enough to even pay the interest portion and caused the loan balance to increase (negative amortization), a payment that covers just the monthly interest, a payment that will pay off the mortgage in 30 years and a payment that will pay off the mortgage in 15 years. In reality, this loan provides the borrower a limitless number of payment options as long as the payment is at least enough to cover the minimum payment.

Not only did most borrowers not understand this loan but, unfortunately, its use was abused by an element of mortgage originators who placed unsuspecting borrowers into these mortgages even though it was clear they did not understand them. This was a misunderstood loan that often had devastating results for borrowers who did not understand them. Needless to say, the Option ARM is no longer available.

The other product that is still available today that provides payment options is the ‘interest-only’ mortgage. This loan is available in both 30 year fixed rate loans as well as adjustable rate loans. They typically allow the borrower to pay just the interest portion of the mortgage for the first 10 years.

Perhaps it is the name of this product that has caused so much confusion because it is really the simplest of all possible loans. Borrowers seem to get confused by the word ‘only’, which implies that a borrower has no other choice other than to pay just the interest and therefore is never able to chip away at the principal.

In fact, the ‘interest-only’ loan also provides a limitless supply of payment options as long as the borrower pays at least the interest that is owed each month. It gives borrowers the option to chip away at the principal each month if they want to.

There is quite a difference in payments when comparing a 30 year fixed rate, fully amortizing loan with an ARM that is fixed for the first five or seven years and allows an interest-only payment. For example, a $400,000 mortgage, amortized over 30 years at today’s rate of 4.75 percent requires a monthly payment of $2087 while the 5/1 ARM at a rate of 3.5 percent for the first five years with an interest-only option requires a minimum payment of just $1167 per month. It should be noted that there is a pricing hit of nearly one half of one percent in rate for the 30 year fixed rate loan with an interest-only option.

This is an excellent loan for borrowers who are only expecting to keep their homes in place for 5 years or less.

This column is written every Saturday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 of email him at Peter@SantaCruzHomeFinance.com.