An option ARM loan is an adjustable rate mortgage that allows you to choose the type of payment you're going to make each month. More correctly called "Optional Payment Adjustable Rate Mortgages," option ARM loans offer payment flexibility for the borrower.
With that flexibility, though, comes risk. If you fully understand the risk, though, an option ARM loan may be right for your situation.
With an option ARM loan, your mortgage statement each month will offer you a choice of four payment options:
1. Minimum payment. This is the minimum payment set by your mortgage contract. Usually the minimum payment is less than the interest due on your mortgage payment for that month. The amount of interest that you do not pay if you make a minimum payment is added to the principal balance of your mortgage.
2. Interest-only payments. With this payment option, you're paying only the interest due for the month, but are not applying any money to your principal balance.
3. A traditional payment based upon a 30 year mortgage period. You're paying the same amount of principal and interest as you would on a 30 year mortgage.
4. A traditional payment based upon a 15 year mortgage period. Again, you're making the same principal and interest payments as if you had a 15 year mortgage.
Payment options #1 and #2 are the source of risk for borrowers. In each case, the borrower is not paying the full amount due. Instead, the amount that is not paid is added to the principal balance. In other words, if you continually make minimum payments or interest-only payments, the amount you owe on your mortgage increases, not decreases. This is called negative amortization.
Option ARM loans have initial interest rates that are extremely low. Usually, though, these low initial interest rates last for a month or two. After that, the interest rate on the loan rises to a rate comparable to other types of loans.
Option ARM loans also have what is called a recalculation period. Usually the recalculation period is at the five-year mark on your loan. At this time, the lender recalculates your mortgage based upon the remaining period of your loan. As explained above, if you've been making minimum payments or interest-only payments, or if market interest payments have increased, your principal balance has increased. You now owe more, and have less time to pay off that principal balance. And, at this recalculation period, you no longer have the option to make minimum or interest-only payments. You will be making principal and interest payments for the duration of your mortgage, and your monthly payments may be substantially higher than what they were.
If your principal balance rises above a set limit, the recalculation of your mortgage may happen sooner than five years.
All of the above is not intended to disparage option ARM loans. For many people, they work very well. For example, some people have incomes that fluctuate seasonally. An option ARM loan allows them to make a smaller monthly payment when their income is low, and then make up the difference when their income increases.
The Federal Reserve Board offers a consumer handbook on adjustable rate mortgages, including option ARM loans, and can be found at www.federalreserve.gov/pubs/arms/arms_english.htm
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