option-arm-basicsOption ARMs are a footnote in mortgage history as they aren’t offered anymore. They were controversial instruments that could result in negative amortization, one of many issues that contributed to the mortgage crash a few years ago. We present this information for those that may have heard about Option ARMs and wanted to understand more about how they worked.

What is an option ARM? The term ARM means Adjustable Rate Mortgage, where the mortgage interest rate changes each month and your ARM mortgage payment is adjusted each year. The ‘option’ aspect refers to the fact that you can decide how much you pay each month from a range of options offered to you.

What does this mean in real terms? You can choose an interest only option, or make a minimum payment of your loan that in many cases is less than the interest due.  You therefore start off with negative equity on your home.  So what’s the attraction of that! It seems a very negative way of paying a mortgage. Not always!

Recognizing an Option ARM

If you see the term ‘option’ offered with your mortgage loan, then it is likely to be an option ARM. If you are not sure, then ask! Too few people ask their mortgage providers to explain exactly what they are signing up for.  There are some advantages of an option ARM, and many people prefer them.

However, it is not something that you should agree to unless you fully understand what it is.  You must be fully aware of the pros and cons of such arrangements, because if things go wrong it can be too late to put them right.  Here are some advantages that attract many people.

Advantages on an option ARM

If you believe that you will be earning a lot more next year, then this type of  ARM offers a low first-year payment. You can get a 1% interest rate for your first year, but it can then rise rapidly year on year after that. It is the prospective interest rate increase that you should consider.  You must ask what that might be, and in many cases it will appear fairly reasonable.

The low initial payment will enable you to purchase more expensive real estate than you normally would. That’s because the low interest rate makes them more affordable, and you are sure your increase in income next year will look after the expected increase in your mortgage payment – but what if it doesn’t?

Risks of Taking an Option Adjustable Rate Mortgage

ARMs are generally OK, but when they come with the word ‘option’ in front they can come with some risks attached. Here are some of these, one of which you might already have anticipated.

Payment Increase: If you have chosen the minimum payment option, your monthly payment will switch from a low rate to a good bit higher in a sudden jump from one month to the next. This usually happens after your first year.

Maximum Interest Rate:  You will be quoted a maximum interest rate when you take this type of mortgage. However, irrespective of that, your mortgage will become fully amortized after 5-10 years using the rate applying at that time.

Sharp Payment Increase: It is possible for you still to be in negative equity at this time due to the low interest rate and also if you have taken the ‘interest only’ option. The increase in your monthly payment can be considerable when what you still owe is fully amortized over the remaining term of your mortgage loan.  In fact, it could break you unless you were fully aware of this from day 1.

Maximum Negative Balance:  Your loan will have a maximum negative balance applied. This can be as high as 125% of your original mortgage loan. If your mortgage balance hits this then it will immediately be fully amortized, and your monthly payments will again be hiked up.

Why Take an Option ARM?

With all these negatives in your mind, why would anyone take an option ARM? The main benefit is that payments are low early in the life of your mortgage. For homeowners that have a good expectation of higher earnings within a few years, an option ARM might have been a good option for them. For those intending to sell their home in the short term, then the negative equity issue may have been a barrier to entering an Option ARM.