Option ARM (Adjustable-Rate Mortgage)

An Option ARM is a type of adjustable-rate mortgage that allows the borrower to select from different payment options each month, including fully amortizing payments, interest-only payments, and minimum payments resulting in negative amortization.
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Overview

An Option ARM (Adjustable-Rate Mortgage) is a type of adjustable-rate mortgage that provides borrowers with a selection of different monthly payment methods. Borrowers can choose among these options at each payment period, thus catering to those with fluctuating income or expenses. This flexibility allows for payments that could be fully amortizing, interest-only, or minimum payments that can lead to negative amortization.

Examples

  1. Fully Amortizing Payment: Jane has an Option ARM. She decides to make a fully amortizing payment, ensuring that her monthly payment covers both principal and interest, sufficient to pay off the loan by the end of its term.

  2. Interest-Only Payment: Steve chooses to pay only the interest on his Option ARM for a given month because he had high unexpected expenses. This means his payment is lower, but he does not reduce the principal.

  3. Minimum Payment Resulting in Negative Amortization: Lisa opts to make the minimum payment on her loan. This amount is less than the interest accrued for the month, causing the unpaid interest to be added to the loan principal, resulting in negative amortization.

Frequently Asked Questions

How does negative amortization work in an Option ARM?

Negative amortization occurs when the minimum payment made is less than the accruing interest, causing the loan principal to increase over time. This means you owe more than you initially borrowed.

What are the risks associated with Option ARMs?

The primary risk is negative amortization, which can increase the overall debt. Additionally, initial payment options may be artificially low and can rise significantly when the loan recasts.

Are Option ARMs suitable for all borrowers?

Option ARMs may suit borrowers with fluctuating incomes or who expect their financial situation to improve over time. They are generally not advisable for those on a fixed income due to the potential for payment increases and negative amortization.

  • Adjustable-Rate Mortgage (ARM): A mortgage with an interest rate that can change periodically, based on changes in a corresponding financial index.

  • Negative Amortization: A situation where the loan payment is less than the interest charged, causing unpaid interest to be added to the outstanding loan balance.

  • Interest-Only Mortgage: A mortgage in which the borrower pays only the interest for a set period, with the principal remaining unchanged.

  • Fully Amortizing Payment: A payment that covers both principal and interest, ensuring the loan is paid off by the end of its term.

Online References

  1. Investopedia - Option ARM
  2. The Mortgage Reports - Understanding Option ARM
  3. Bankrate - Option ARM

Suggested Books for Further Studies

  1. “The Mortgage Encyclopedia: The Authoritative Guide to Mortgage Programs, Practices, Prices and Pitfalls, Second Edition” by Jack Guttentag
  2. “Mortgage Ripoffs and Money Savers: An Industry Insider Explains How to Save Thousands on Your Mortgage or Re-Finance” by Carolyn Warren
  3. “Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan” by David Reed

Fundamentals of Option ARMs: Real Estate Financing Quiz

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