What is an Option ARM?

Adam Hill
Adam Hill
Man climbing a rope
Man climbing a rope

In the world of mortgage financing, there are two basic types of mortgages: fixed-rate, and adjustable rate mortgages, or ARMs. Each of these categories has many options to choose from, depending on the homeowner and the prevailing conditions in the housing market. One type of ARM is the option ARM, which is typically a 30-year ARM that initially offers the borrower four different payment options each month. This gives the buyer added flexibility in paying off the loan, and providing more liquidity in the day-to-day operations of the household.

The four basic payment options that exist are: the minimum payment option; the interest-only payment; the 30-year payment; and the 15-year payment. The minimum payment is, not surprisingly, the lowest of the four payments offered with an option ARM. The minimum payment covers neither the entire principal amount for the month nor the accrued interest. The interest-only payment is exactly what it sounds like -- simply paying the interest accrued for the month, which does not reduce the principal balance.

The 30-year payment is the payment that most people are used to making on their mortgages. It pays the principal and interest, and will pay off the mortgage in 30 years if paid consistently. The 15-year payment, also called the accelerated payment option, will pay the loan off in 15 years. This is the highest of the four payment options in an option ARM, for this reason. More than half the total interest costs of a 30-year loan can be eliminated with the 15-year payment option, making it a wise choice for those buyers who have a reliable way to make this larger payment every month.

The option ARM is best suited to sophisticated buyers with growing incomes, especially if their incomes fluctuate in predictable seasonal patterns. An informed and prudent borrower will limit the number of times he uses the minimum payment option, to avoid a phenomenon called negative amortization. Simply put, this is when the actual loan balance increases beyond the amount that was originally loaned. Another main risk of the option ARM is “payment shock,” which occurs when the low initial interest rate adjusts to a higher one. It can also happen when the unpaid principal balance reaches the maximum limit of negative amortization, causing the minimum payment to jump dramatically, depending on the exact loan terms.

Overall, it is highly important for every home buyer to be familiar with the mortgage options available to him, and especially well-versed on the terms of his own loan. This reduces the chance that the buyer will go into default because of unpleasant surprises such as payment shock. While the option ARM is the best type of loan for some buyers, all buyers should carefully consider the risks when taking a mortgage loan, and be sure that they have the means to make the monthly payments.

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