Borrowers are given flexibility in how much they pay each month during the initial term of the loan. The four options normally given are;

1. An amount that will fully amortize the loan over 30 years.
2. An amount that will fully amortize the loan over 15 years.
3. An amount that will pay all of the interest that accrued during the previous month a.k.a "interest only."
4. A minimum payment that is less than the monthly accrued interest a.k.a. "negative amortization." Negative amortization results in an increase in the outstanding loan balance.

The loan "resets" at the end of five years. The payment is then calculated to be the amount that will fully amortize the loan over the remaining 25 year term of the loan.

However, if the borrower chooses the negative amortization feature, then the loan will reset whenever the total loan balance equals 115% of the original loan balance. The amortization period used to calculate the monthly payment will equal the number of years and months left on the loan.

Loans made to borrowers who do not qualify for the best market interest rates because of their deficient credit history.

Loan rates and terms vary but a popular subprime loan is the 2/28 ARM. This loan carries a fixed interest rate for the first two years. The rate is normally higher than the prime rate. At the end of two years, the loan becomes a variable rate loan. It is common that the margins on these loans will range from 5% to 7%. When combined with the index, it normally results in very high interest rate loans.

As a general rule, we believe that borrowers should avoid these loans. This is especially true of the Alt-A, Pay Option ARM and Subprime loans. People who use any one of these three loan products normally find it necessary to refinance when the loan hits it's reset period. There are many times when refinancing is not possible because of declining real estate values, changes in the borrower's circumstances or changes in lending criteria.

However, these loans are not totally without merit. Here are some situations when they might be appropriate;

Prime ARM loans are appropriate for borrowers willing to take on additional risk and who do not plan on owning a home for more than a few years.

Many prospective buyers find themselves watching real estate prices in a declining market while they wait for prices to reach an affordable level for them. Prospective buyers, especially those young buyers who anticipate substantial increases in their income, may want to consider Alt-A, Pay Option ARM or Subprime loans if home prices start to increase before they decline to an affordable level. These loans should be avoided when prices have appreciated substantially. Buyers who used this strategy and did refinance into fixed rate mortgages have probably benefited greatly. Most buyers who used this strategy near the peak of the real estate market now find themselves in difficult financial times because they are facing resetting interest rates and they are unable to refinance into more affordable loan products.