What are Option ARMs?

Mary McMahon
Mary McMahon

Option adjustable rate mortgages (ARMs) are adjustable rate mortgages which offer several different repayment options to borrowers. These mortgages are often touted as being highly flexible and useful for people who are trying to buy a first home, especially in the case of people with incomes which are growing. However, there are some serious dangers to an option ARM which should be carefully considered before committing to this type of loan.

Man climbing a rope
Man climbing a rope

As with other adjustable rate mortgages, the interest rate on the mortgage changes, rather than being fixed. This means that when interest rates go down, so does the interest rate on the mortgage, but when interest rates rise, the mortgage interest rate also goes up. To compensate for the changes in the interest rate, the payments are periodically recalculated or “recast” in banking-speak, which means that the amounts of mortgage payments can vary from year to year, and sometimes month to month.

With option ARMs, the borrower has an option each month. He or she can make an interest-only payment, a minimum payment, a 15 year fully amortizing payment, or a 30 year fully amortizing payment. When a borrower has a tough month, he or she might opt to pay the minimum payment, thereby keeping the mortgage in good standing. In a good month, the borrower could opt for the 30 year fully amortizing payment, a payment which is designed to keep the mortgage on track for being paid off in a 30 year term. Or, for borrowers who want to increase equity in the home and pay off the loan more quickly, a 15 year fully amortizing payment could be submitted.

Typically, option ARMs start out with a very low introductory rate, which keeps payments very low. For borrowers who are not financial wizards, this can make the mortgage seem very appealing, as the monthly payments look like they will be easy to cope with, especially if a borrower only looks at the minimum payments, rather than the amortizing payments. However, when the rates are recast, borrowers can experience “payment shock” as the monthly payments go up to compensate for changes in the interest rate.

One of the major dangers of option ARMs is that they allow negative amortization, which means that the borrower can pay less than the accrued interest every month, with the unpaid interest being added to the principal balance. Over time, the loan will actually grow, rather than becoming smaller with the monthly payments. If an option ARM does become a negative amortization mortgage, the bank may recast the rates to keep the borrower on track, causing a subsequent jump in monthly payments.

These so-called pick-a-payment loans can be very useful for financially responsible borrowers who are able to sit down and calculate the math involved to ensure that they are actively paying down their mortgages. Taking out option ARMs can be useful for someone with fluctuating income, as it allows them to pay down the loan during periods of high income, reverting to lower payments in months when there is less money available. One important thing to consider when looking at an option ARM is the margin of the loan, the amount that the bank can add to the base interest rate. The margin of an option ARM will be fixed at the time the loan is issued, while the base interest rate can fluctuate, so the lower the margin, the less susceptible the borrower will be to interest rate fluctuations.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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