By Jeffrey Chalmers

As reported by ForeclosuresMass, foreclosures are at an all time high in Massachusetts. Part of the reason is due to homebuyers taking on more than they can handle through adjustable rate mortgages (ARMs). One of the riskier programs is the Option ARM.

The Option ARM allows people to purchase a property despite less-than-ideal circumstances, such as slow credit or self-employment. A self-employed person, for example, can get a no-doc Option ARM with a 1% teaser rate, which allows him to get into the property and make lower monthly payments for a set period of time.

While the initial term seems "consumer friendly," the Option ARM can be a very unconventional loan program because it's based on negative amortization.

Here's how it works: Let's say you borrow $200,000. With a conventional mortgage, your monthly payment is $2,000. With an Option ARM, your payment is knocked down to $1,000 or $800. So you're "saving" $1,000 to $1,200 dollars each month. However, what many consumers don't know is that a portion of this "savings" is then tacked on to the back end of the principal.

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What this means is that your principal increases each month, rather than decreasing, as with a conventional mortgage.

Option ARMs were a no-brainer for savvy investors when values were going up and you could count on quickly flipping a property. You could buy a property with little money down, carry a smaller mortgage, and put your cash into upgrading the property.

Now that the market has slowed down, I recommend to investors that they steer clear of Option ARMs for three reasons:

1. Stricter lending practices - Because of the high number of foreclosures, banks are tightening their lending practices. According to a recent Wall Street Journal article, 15% of domestic banks reported they had tightened their credit standards in the last three months. This means you're going to find it harder to get this type of loan through a no-doc program.

2. Prepayment penalties - Lenders are adding penalties to Option ARMs that force borrowers to pay three months or more of interest if the loan is refinanced within three years - a huge whammy if you need to refinance because your property hasn't sold and you're suddenly stuck holding a loan whose rate just adjusted to 7.5%.

3. A slow market - The current market is making it harder to flip properties quickly. You can seriously jeopardize your financial security if you're stuck with a property that isn't moving and a loan whose rate is adjusting every six months.

4. Although the Option ARM may not be the best loan program right now, that doesn't mean you should steer clear of ARMs altogether. Despite the negative press, a number of ARM programs exist that won't have you turning into another foreclosure statistic.

Before I list some of the more popular ARM programs, let me first familiarize you with basic ARM "lingo." One reason people get into trouble with ARMs is because they don't understand how an ARM works.

Before you begin shopping for an ARM loan, do a thorough financial plan to determine exactly how much loan you can afford, and educate yourself on the types of loans available.

When researching ARM programs, keep track of each loan option and its features. I provide my clients with a mortgage comparison checklist in order to evaluate the following terms:

• Initial adjustment period - The length of time the interest rate is fixed initially. For example, if the initial adjustment period is six months, then the interest rate remains fixed for the first six months. Beginning with month seven, the loan adjusts at various intervals.

• Regular adjustment period - The frequency at which the interest rate adjusts. If the regular adjustment period is six months, then the loan adjusts every six months.

• First adjustment cap - The maximum amount the interest rate can increase when it adjusts for the first time.

• Regular adjustment cap - The maximum the interest rate can adjust up or down each adjustment period.

• Lifetime cap - The maximum interest rate allowed over the life of the loan.

• Index - This is the one feature that confuses many people. Each loan is based on an index: the prime rate, T-bill rate, Libor, 6 month CD rate, or COFI (11th District Cost of Funds Index). The rate for each index can usually be found in business newspapers or online.

  What you need to know about indices is that each one moves at its own rate. Therefore, it's imperative you ask your lender on what index the loan is based - and when it adjusts.

  The Libor index, for example, is the interest rate international banks in London charge when lending to each other. Indices are quoted for maturities of one, three, six, and twelve months. The COFI, on the other hand, is the average monthly cost of the interest expenses incurred by members of the 11th District of the Federal Home Loan Bank System on items such as passbook savings accounts, CDs, and checking accounts.

  The Libor index can move very aggressively, while the COFI moves very slowly and lags behind the market. For investors, a COFI ARM is an advantage when interest rates are rising but a disadvantage when rates are falling. A Libor-based ARM, on the other hand, can readjust 1 - 2% every six months - making it a poor choice if the market is slow. Ditto for the Certificate of Deposit (CD) ARM. The CD rate is very volatile and changes quickly with the market.

• Margin - A fixed number that's added to the index to arrive at the ARM rate.

• Fully-indexed rate - This is equal to the index plus the margin. Your loan always adjusts to this rate.

• APR - The annual percentage rate (APR) is a key indicator of what you'll pay in fees and closing costs. Read your Truth in Lending (TIL) statement carefully to ensure the rate you were quoted is the rate you're actually being charged. (State law requires that within three days of taking an application, lenders provide you with the TIL statement and Good Faith Estimate.)

• Conversion options - Some ARMs have an option that allows you to convert the ARM to a fixed-rate loan after a set period. Exercising the option must occur within a predetermined time frame; the fixed rate is determined by a formula. For example, a one-year T-bill ARM may be converted to a fixed-rate loan during the first five years on its adjustment date - i.e. you can convert during the thirteenth, twenty-fifth, thirty-seventh, forty-ninth, or sixty-first month. In some situations, the lender may require a conversion fee.

ARM programs that won't send you to the poorhouse

When researching ARM programs, don't let an aggressive lender push you into a loan you don't understand. Ask for the loan's rates, the index on which it's based and when it adjusts, and if any prepayment penalties are attached.

The following ARM programs are excellent choices for real estate investors as they allow you to finance a property and make minimum payments while either upgrading the property or holding on to it for a few years:

One Year ARM programs - This is the most common type of ARM. The interest rate is adjusted once every year for 30 years - and can go up or down depending on its index.

Hybrid ARM programs - These types of ARMs offer long-term investors the best of both worlds. Generally, the loan is fixed for a set period of years (3, 5, 7 or 10) and then becomes an adjustable rate loan thereafter. Some hybrid ARMs may work the other way, with the adjustment period coming first; the loan then converts into a fixed.

Interest Only Programs - With Interest Only loans, you combine maximum borrowing capacity with a minimum monthly payment. Although not an ARM in the strict sense of the term, Interest Only loans do adjust after a set time period. The "interest only" feature is usually good for a limited time period (i.e. 10 years). After that your payments adjust in order for you to pay off the loan in the required timeframe. The Interest Only loan is ideal for investors right now because it allows you to purchase a property and make minimum payments while you're rehabbing it. It also gives you the breathing space you need to ride out the market until your property sells.

If you're a new investor, don't let the negative press surrounding ARMs deter you from considering this type of financing. Despite what you hear, an ARM is still a great way to get into real estate investing. To find the best loan, educate yourself on the type of ARM that's right for your situation, understand the loan's terms and rates, and take your time when considering lenders and loan programs.

Jeffrey Chalmers is the President of Real Solutions LLC, a one-stop real estate service. For more information, visit the Real Solutions website at www.ClicknCompare.com. You can also call Jeffrey at 877-CLOSE-57 (x 901) or email him at jchalmers@clicknclose.net

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