Originally Posted by Mxfrank

This type of loan is called an "option ARM," for obvious reasons. I had thought we had seen the last of them after 2008, I guess not. There are a lot of trap doors with these loans, in addition to the main trap of owing more principal over time. Most of them were balloon loans, with temptingly low initial rates. The problem with this is that the borrower would often qualify for a loan that would have been unaffordable without the teaser rate. The reasoning was that housing prices were skyrocketing, so the borrower could flip the house and pocket money for doing nothing or the bank could foreclose and get more than what was owed. In the worst case, the loan could be refinanced at a new teaser rate. In the event, neither end game worked out. The fallacy was that housing values were rising because unqualified flippers were able to get financing. As long as there was a flow of stupid money into the real estate market, it works, but eventually it had to stop. Of course, this was fraud by the bank and the borrower, BOTH of whom knew the loan was a pure gamble on rising real estate prices. And yet, nobody went to jail.

As with legitimate ARM's, the interest rate adjusted based on an index. The index used most of the time was Libor. And of course, prior to the financial crisis, Libor was famously manipulated by a consortium of major banks. For that, there were fines and apologies, but no jail time.

If you're shopping for a mortgage in the US, you should begin by pricing out a fixed 30 year with zero points and 80% down. That's the honest loan, and it's going to best define what you can really afford. Now, you may pick a different loan for cashflow or down payment reasons. But the house for which you qualify at fixed thirty is the most house you can safely buy. You may want more, and an ARM may promise more, but the road to financial hell is paved on wishful thinking. And since you know the baseline cost, your task is to figure out where the extra expense has been hidden in your particular loan.