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You'll see Option-ARM terms described like this:

$500,000 loan, 1.5% start rate, 2.80% margin over cost of funds, 11.95% lifetime cap, 125%/10-year reset cap

The initial MINIMUM payment is based on the 1.5% start rate, and changes +/- 7.5% per year. That is a mathematical formula that has nothing to do with interest rates.

When you first hear that, it's hard to fathom how a mortgage payment can adjust with no regard to interest rates.  Because in every other case, it's the interest rate that determines the payment.

The minimum payment is initially based on an artificially-low 'teaser' interest rate, but that's the only time it has anything to do with interest.

In this example, that MINIMUM payment is:

1st year -  $1,725.60
2nd year -$1,855.02
3rd year - $1,994.15
4th year - $2,143.71
and so on.

(take the last payment X 1.075 to find new pmt.)

The FULLY-AMORTIZED payment IS figured by an interest rate, and it's determined by adding the margin to the index. Today's index is 4.11% + 2.80 = 6.91%.

The fully-amortized payment on the $500,000 is $3,296.35.

If you only pay the minimum payment, you ADD THE DIFFERENCE onto the loan balance. - In this case, add $1,570.75/mo.

Once you've added/deferred enough to reach 125% of the original loan balance, the loan resets and you then pay principal and interest monthly, amortized over the remainder of the loan.

In this example, the simple math shows that the reset kicks in around month 80, or between the sixth and seventh year. But remember that the minimum payment is going up every year, so if rates stay the same or go down, the gap is narrowed and the reset could be extended further out. In any case, the loan will reset after the tenth year - heck, you have to start paying it down sooner or later.

Obviously if rates go up, the deferred-interest gap widens, and the reset could kick in sooner.

This is your standard World Savings Neg-Am mortgage, also used by Downey Savings and Washington Mutual.

Countrywide and others tweaked the 125%/10-year reset cap to 115% or five years, and those borrowers who didn't catch it are looking at a reset as soon as 30 months, if they aren't careful.

There was an example in Business Week that showed a reset after 30 months, and the payment went from $1,600 to $4,000 per month. Ouch.

The mortgage industry better be working on a way to re-negotiate those terms (like raising from 115% to 125%), or they will be owning A LOT of houses in the near future. Not sure how they can re-negotiate on loans sold to MBS buyers, but somebody better do something.

John Dugan, the Comptroller of the Currency, was recently quoted as saying that when rates go from 6% to 8% on a Option-ARM, the payments will double.  That's incorrect. 

Payments could double (or higher) IF THEY ARE RESET EARLY - is the accurate fact.

Here's the real change in payment when rates go up 2%:

$3,296.35 at 6.91%

$3,990.78 at 8.91%

A hefty $694.43 per month increase, but not double.

And you still have the MINIMUM payment available, or any amount in between.

An interesting fact: When interest rates dropped from 10% in 1990 to 7% in 1994, those who had these Option-ARMS experieced positive amortization. 

Their minimum payment was only coming down by 7.5% each year, and the interest rates came down faster - and you HAD to pay the minimum payment.  As a result, a big chuck of the payment, in some cases, 50%, was going towards principal reduction.

Typically once you get past the first few years of an artificially low minimum payment (which was set by the teaser rate) the minimum payment and the fully-amortized payment tend to stay pretty close to one another.

That's a lot of explanation, let me know if you have any questions.