If you have a so-called option ARM, where you get a choice of the payment structure you want, I’ll bet you didn’t know about an insidious clause in that loan. In many option loans, you can choose a minimum payment, much like a credit card, where you just make a small payment, but it doesn’t cover all the principal and interest of a “normally amortized loan”. I actually had one of these loans and my options were (in order of lower to higher payments) :

1. a “minimum payment”,
2. an “interest only” payment,
3. a 30 year amortization payment and
4. a 15-year amortization payment.

In all of these loans, however, if you keep choosing that minimum payment, not only will you get deeper in debt with every payment (just like that minimum payment on your credit cards), but if you reach of 110-125% of the original loan principal, your loan hits “an acceleration clause” and the bank can call your note due.

Whenever a loan is accelerated, it means that entire loan amount is immediately due. Yes, right then and there, even if the original loan terms were supposed to be spread out over time in payments. This means that if you can’t pay off the loan in full at the moment your loan amount is 110%, the bank can foreclose on the loan, and consequently, your house.

According to a Business Week article:

According to a new study by professors from Columbia and New York universities, the “optimal” mortgage in a perfect world is precisely that kind of loan—an adjustable-rate mortgage with an option for negative amortization and a ban (or at least severe restriction) on prepayment.

Crazy? Not as crazy as you might think. The key, according to professors Tomasz Piskorski of Columbia Business School and Alexei Tchistyi of New York University’s Stern School of Business, is that this kind of mortgage is optimal only in a perfect world—namely, one in which borrowers are fully rational and always do what’s in their own best interest.

In the real world that we are condemned to inhabit, many people who took out option ARMs foolishly believed that they would never have to pay more than the bare minimum monthly payment. They have stuck with that minimum payment month after month, causing their loan principal to go up and up. At some point they have hit (or soon will hit) a ceiling on total permissible mortgage debt, at which point the terms change and their monthly payments soar to unaffordable levels. Next step: default and foreclosure.

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