What is an Option ARM Loan?
An option ARM loan is one of several mortgages available to borrowers. It’s a program that features flexibility to choose among payment options (the “option”) and an adjustable rate (that’s where the “ARM” comes from).
For example, your option ARM loan might allow you to make any of the following payments:
- A low “minimum payment”
- A fully amortizing payment (for a 15, 30, or 40 year amortization schedule, for example)
- Interest only
Based on your budget for a given month, you pick the payment that you can afford. Indeed, you’ll find option ARM mortgages referred to as:
- Pick a payment loans
- Payment option ARMs
- Cash-flow loans
- 1% mortgage loans
Pitfalls of Option ARM Loans
While the flexibility built in to option ARM loans is nice, it comes with some risks. First, you don’t build equity unless you make the bigger (amortizing) payments. Given a choice between a large payment and a small payment, which one will you choose? With the smaller payments, you’ll actually owe more on your house at the end of the month than you did at the beginning. The option ARM loan becomes a negative amortization loan!
In addition, those small payments don’t last forever. Sooner or later the bank will want to put you back on track to pay the loan off. They will “recast” your loan at given intervals (every 5 years, for example), and/or when you owe too much on the home (110% or 120%, for example) due to negative amortization. When they recast, they set the loan on track to fully amortize over its remaining life, and your “guaranteed minimum payment” can increase sharply. If your budget can’t afford this increase, you’re in trouble.
Consider an option ARM loan nightmare: you’ve been paying the minimum payments on your loan while your mortgage balance increases. Next, the loan is recast and you can’t afford the new payments. What do you do? You can sell the house, but you’ll have to write a check at closing because your loan balance is greater than the home’s value.
How to Use Option ARM Loans
If you must use an option ARM loan, make sure it makes sense. These are best used by folks who just want flexibility, but who are otherwise financially secure. Don’t use an option ARM loan to get into a more expensive home than you can afford.
