This is very good question. Before I answer your question we must understand the way the pay option ARM works. The Pay Option ARM is loan that has an index rate, margin, start rate, and fully indexed rate. Typical index rates tied to the Pay Option ARM are the LIBOR, COFI, and MTA. The lender adds a margin to the index rate which gives the fully indexed rate. The loan also has a start rate for low payments. The start rate can range from 1% to 4%.
The pay option ARM offers four payment options each month. The minimum payment, interest only, 30 Yr. Principal and Interest, and 15 Yr. Principal and Interest payments. The start rate or minimum payment is fixed for 12 months then adjusts at 7.5% each year causing the payment to go up. The interest only, 30 Yr. P&I, and 15 Yr. P&I payment adjust every month causing the payment to either increase or decrease.
The difference between the minimum payment and interest only payment is called deferred interest and gets added back to your loan causing it to increase. The minimum payment keeps increasing every year because the loan will eventually be paid off at the end of the life of the loan. This loan can potentially cause negative amortization. Therefore, lenders allow a maximum of 115% LTV before it recasts. Once the loan has reached its recast period the loan payments will be applied towards the principal balance and interest.
Since the loan is simple interest, any additional payments can be applied towards the principal balance. However, the purpose of this loan was to increase cash flow monthly allowing homeowners to use the monthly savings and invest it in a high yield liquid investment vehicle.
Homeowners that know how to use this loan and see the value this loan provides use this loan to their advantage and eventually increase their total net worth and reach financial freedom sooner. They defer interest yet have those monies working for them in a liquid investment with a rate of return, for example, of 10%.
If I were you, I would sit with a financial planner and design a plan to allocate the savings the minimum payment provides.
Looking at the number that you gave, I think you are getting the wrong information. The option arm program has a minimum payment rate (this is the 1% or 2% rate that is advertised). This is not your actual interest rate. Your lender is required to give you the actual interest rate. On an option arm, this is currently in the 7% to 8% range.
Your statement should give you four payment options.
Minimum Payment – This is the 1% payment
Interest Only – This is calculated at the actual interest rate
30 Year Fixed – Calculated at the actual interest rate
15 Year Fixed – Calculated at the actual interest rate
Running the numbers, and I will use 7.5% as your actual interest rate, these may be what your payment options would look like.
Minimum Payment: $804
Interest Only: $1,563
30 Year Fixed: $1,748
15 Year Fixed: $2,318
If you make any payment less than the interest only, the difference will be added onto the principal balance. If you are paying $1,200, there is an additional $363 being added to your principal balance each month. You would need to pay at least the interest only payment to keep the principal balance where it is.
If you wanted to pay down any principal, you would need to pay more than the interest only payment. Anything over the interest only payment will reduce the principal.
Be very careful, the information you have is not correct. The minimum payment is not an interest only payment. They are two different payments and calculated at different rates.