How will I know an FPARM when I see one?

Ask the loan provider if the rate adjusts monthly, and if negative amortization is allowed. If the answer to both questions is "yes," you almost certainly have an FPARM. Their names are all over the lot and include: "1 Month Option Arm"; "12 MTA Pay Option ARM"; "Pick a Payment Loan"; "1-Month MTA"; "Cash Flow Option Loan"; and "Pay Option ARM."

What will an FPARM do for me?

Their main selling point is the low minimum payment in year 1. It is calculated at the interest rate in month 1, which can be as low as 1 percent, and it rises by only 7.5 percent a year for some years.

The low initial payment allows borrowers to buy more costly houses than would be possible otherwise or use the monthly payment savings for other purposes. You don't need a list from me of ways to use the cash flow savings because your loan provider is sure to oblige. What they are less likely to give you is a sense of the risks you will face down the road.

What are the risks?

For those electing the minimum-payment option, the major risk is "payment shock" – a sudden and sharp increase in the payment for which they are not prepared.

The rule that the minimum payment can rise by no more than 7.5 percent a year has two exceptions. The first is that every 5 or 10 years the payment must be "recast" to become fully amortizing. It is raised to the amount that will pay off the loan within the remaining term at the then current interest rate – regardless of how large an increase in payment is required.

The second exception is that the loan balance cannot exceed a negative amortization maximum, which can range from 110 percent to 125 percent of the original loan balance. If the balance hits the negative amortization maximum, which can happen before five years have elapsed if interest rates have gone up, the payment is immediately raised to the fully amortizing level.

Either the recast provision or the negative amortization cap can result in serious payment shock.

How do I protect myself against this risk?

Three ways:

1. Measure the risk: You can do this yourself using my new FPARM calculator 7ci. It will show you what will happen to the payment on your FPARM if interest rates follow any of a number of future scenarios selected by you. An important side benefit is that the calculator lists the information you need, which you want for shopping purposes anyway.

2. Minimize the risk by shopping for the lowest margin. The margin on your loan is the amount added to the interest rate index to get your rate. Since the margin affects the rate in months 2-360, it is the most critical price variable on an FPARM. The lower the margin, the lower your cost and your vulnerability to payment shock. Note: The margin is not a required disclosure so don't expect that it will necessarily be volunteered.

3. Minimize the risk by taking the highest initial payment you can afford. The higher your initial payment, the smaller the potential payment shock down the road. Since the initial payment is determined by the interest rate in month 1, you should select the highest rate that results in a payment with which you are comfortable. Asking for a higher rate sounds a little strange, but remember, the quoted rate holds only for one month.

Should I shop for an FPARM?

Yes, emphatically, but not for the rate. Your major focus should be on the margin, because that is what determines your rate after the first month. Your second priority should be the maximum rate. Your third priority should be total lender fees.

The good news about monthly ARMs is that lenders don't reprice them every day as they do other mortgages, which makes comparison shopping much easier. You don't need a rate lock, but ask the loan provider to specify the margin, maximum rate and fees on paper.