Option adjustable rate mortgages (ARM) are mortgages that begin with a period of time during which borrowers do not have to make any principal payments. Borrowers seeking to minimize their short-term expenses often take out option ARM mortgages rather than conventional loans that require principal and interest payments. Despite the short-term benefits, option ARM mortgages are complicated loan products that benefit some people but cause problems for others.
These mortgages usually have an overall term that lasts between 15 and 30 years, but the interest only period lasts for up to 10 years. A borrower with a conventional mortgage makes a monthly payment that is applied towards both the principal and interest due on the loan. On an ARM mortgage, the borrower defers the principal payments until the interest only term ends. Borrowers can either make a lump-sum principal payment at the end of the interest only term or refinance the home. People who lack the funds to make this payment stand to lose their home if they cannot settle the debt, but many homeowners sell their homes before the interest only period ends.
In order to refinance a property, a borrower must have some equity in the home. In some countries, borrowers can only refinance if they have at least 20 percent equity. No principal payments are made during the interest only period of option ARM mortgages, which means homeowners establish no equity beyond the equity they had when they took out the loan. If home prices fall, borrowers have negative equity, which means the mortgage amount exceeds the property value. People in that situation cannot refinance, and must make the lump sum principal payment or risk losing their home.
Option ARM mortgages have variable interest rates that are based on bond rates and other similar indicators. The rates typically change on either a monthly or annual basis. Rising interest rates result in larger mortgage payments, while falling rates result in minimal borrowing costs. Depending on the rate environment, variable rates can help or harm borrowers.
At the end of the interest only term, the borrower makes a lump sum principal payment and then begins to make monthly principal and interest payments. Borrowers can quickly build up equity in their home, which increases their net worth. Some people experience payment shock, which occurs when the monthly payment rises significantly as a result of adding principal payments into the equation. People who have limited cash flow sometimes have difficulties making mortgage payments as a result of payment shock.