“Your dream home is too pricy?

“No problem. With our flexible-payment options, you can borrow more than you thought. Don’t worry about a crushing payment hike down the road, or that you’ll end up owing more than your home is worth. Only sissies sweat the details.”

If only the ads were so honest. But in today’s frenzied real-estate market, buyers think they can make big money on first, second or third homes. And lenders are eager to help them finance their bets with loans that are the toxic waste of the mortgage industry.

They go by such names as Option ARM, PayOption ARM, Pick-a-Payment or Cash-Flow ARM, according to HSH Associates, the Pompton Plains, N.J., mortgage data firm.

Cut-rate payment

The common denominator: They offer a cut-rate payment option that eventually can leave the homeowner owing more than was borrowed.

As home prices soar, option adjustable-rate mortgages are hot because their low initial payments make it possible to qualify for larger loans. A typical option ARM starts with a rate as low as 1 percent, compared to the nearly 6 percent on a standard 30-year fixed-rate mortgage.

Option ARMs usually give the borrower four choices each month:

A full payment. This covers all the interest owed plus principal, just like an ordinary mortgage.

A bigger-than-required payment. This covers interest and puts extra money toward principal, reducing subsequent interest charges.

An interest-only option. This covers just the interest owed but includes no principal payment, so there’s no progress whittling the debt.

A minimum-payment option. The payment covers only part of the interest owed and nothing on principal.

This is the most dangerous option. The unpaid portion of interest increases the remaining debt, causing interest charges to rise in subsequent months. To make matters worse, the interest rate can go up over time.

HSH figured how this would have worked on a typical option ARM taken out in June 2003 for $100,000. The minimum payment would have been like paying a rate of just 1.5 percent, though the index on which the loan was based was at 3.5 percent. That 2-point shortfall would have added about $100 a month to the debt.

The rate charged on the loan would have risen to nearly 5.5 percent by this June and could be expected to go to more than 6 percent for 2006 and 2007. The minimum payment started at $350 and would likely go to $450 by 2007 – about $350 less than needed to cover all the interest charges.

As a result, after five years the person who borrowed $100,000 would owe nearly $111,000. Had this person borrowed the same amount with a fixed-rate loan at 6 percent – and a $600-per-month payment – the debt would be cut to about $93,000.

In theory, the option ARM might work well for some borrowers, such as those who will have their loans for only a brief time and those with fluctuating incomes and enough discipline to make some bigger-than-required payments to offset the small ones.

An option ARM also might work for a person who could use the minimum-payment option to free up cash for an investment profitable enough to outweigh the growing mortgage debt.

But most option ARM borrowers probably are not in these categories.

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(Jeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at brownjphillynews.com.)

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(c) 2005, The Philadelphia Inquirer.

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AP-NY-07-25-05 0620EDT