The term ARM (adjustable rate mortgage) simply means that the interest rate changes over time based on a moving index.  In this particular case, the product is marketed with a very low introductory rate that steps up over time.  I'm typically able to decide how a feel about a given financial product after some thought, but in this case there are two sides.  I think if we start with a brief overview of the mortgage industry and then look at the positives and negatives this will become a little clearer.

Because houses are expensive, and the government allows you to deduct home mortgage interest from your income taxes, most homes are purchased with debt.  Incidentally, it could be argued that the government incenting home ownership is what the historian Howard Zinn might refer to as a system designed to pacify the middle class for 30 years, but I think that is probably a discussion for another column and/or author.  Intentions aside, the tax break allows you to borrow a rather large sum of money with a very small initial cash outflow.  It's the combination of this powerful leverage and the appreciation of the underlying home that can make a home purchase a great investment.

The Product

The first two payment options, 15 yr and 30 yr, are pretty straightforward, you make monthly payments over the next 15 or 30 years(the 15 yr payment option is more expensive).  The interest only option allows the borrower to pay only the accrued interest on the balance and the “minimum payment” actually lets the borrower pay less than the accrued interest.  The fancy terminology for this is “negative amortization” and it means the balance of your loan will go up over time rather than down.  I should note that there is a limit to the amount of principal you can add to your loan, once a borrower reaches 110% or 125% of the value of their home, the minimum payment increases.  

It's these final two options that I struggle with.

Why Would Anyone Do This?

The prospect of owing more than you borrowed after making payments is a tough sell, but there are a couple of aspects of this product that I find appealing, at least on a theoretical level.  First, the lower monthly payments would allow the borrower to make a larger levered investment (a $300K house versus a $200K house).  Assuming both houses appreciate at  4% annually, the pay option arm customer will be making his or her 4% on a balance that's $100K higher.    The other feature that I like is that the lower payment could allow someone currently living in an apartment to purchase a home, make the levered 4% appreciation for a couple years and then start making higher payments as their income increases or refinance into a conventional loan.  I'm certain that if I had taken out an interest only loan upon graduation from college, I would be in a much better financial position today.

Why I'm Not Sure I Could Recommend This Product

The theoretical benefits of the pay option arm or interest only loan work for me if, and only if, the borrower knows what they are getting into.  The home market is typically relatively stable, but that does not mean that it can't go sideways(or even backwards) for a period of time.  If you finance your home with a option arm or interest only loan, you run the risk of finding yourself underwater.  My fear is that when presented with the option of paying $1000/mo or $700, most people are going to take the lower amount every time without really understanding the ramifications.  Unless your plan is to use this type of financing to either work your way into a larger house or get out of an apartment and into an appreciating asset, this is probably not your best option

I  can imagine the eyes glazing over at this point, so I'll wrap it up.  In my humble opinion, the pay option arm and interest only loan should be viewed as a short term bridge to a bigger house or better investment. They'll get you into a house, but, given the wrong turns of events, can also get you into a world of monetary hurt.