Option Arm Basics: What You Should Know

An option arm is an adjustable-rate mortgage with the added flexibility of being able to choose from a variety of payment options from month to month.  Option Arm’s go by many different names including ‘cash flow option loan’, ‘pick a payment loan’, ‘1-month MTA’, and so forth.

The increased flexibility of these programs can help an individual better manage their cash flow. However, there are certain pitfalls that any borrower considering an option arm should be aware of. Don’t just get lured in by the promise of a low introductory rate. The best way to know if an option arm is the right program for you is to start with the basics.

What are the Options?

Typically, the borrower can choose from 4 different payment options each representing a different loan program. The borrower will have 2 fully amortized payment choices representing a 30-year and a 15-year loan. These will be the highest monthly payment options and the fastest way for the borrower to build up equity. Making additional payments to the principal will build equity even faster. This will further reduce the amount needed to be paid back over the following years.

The 3rd major payment option will represent an interest-only program. The interest rate will change from month to month based on changes in the ARM index. The borrower will basically be paying just the monthly interest expense without putting any money towards the principal of the loan. This option will be available as long as the interest-only payment is higher than the minimum payment option.

The minimum payment option is always going to be just that, the choice that requires the borrower to pay the least amount of money towards the loan. The minimum payment interest rate will be set for a specified time period (usually 1yr). The payment changes annually after that based on limits placed on how much the interest rate can increase or decrease from year to year. After the initial interest rate period, the minimum payment option may not be enough to cover the monthly interest expense that is being incurred. This will lead to ‘deferred interest’ or ‘negative amortization’ and is where the borrower can get into trouble.

Who should use an Option ARM?

Option ARM’s are generally used by borrowers who are not planning to own the property for a long period of time and prefer the flexibility of the monthly payment. Most lenders will recommend that the borrower only goes as low as the interest-only payment option. This ensures that the borrower will never be surprised by the deferred interest that is created when choosing the minimum option. Other individuals use these types of loan programs to buy more houses than they could otherwise afford. For this reason, Option Arm’s are growing in popularity in areas where there is a high cost for housing. The East and West coasts especially. When a borrower uses an Option Arm to buy more houses than they can afford they leave themselves at the mercy of interest rates. Rates rise and so do the borrower’s monthly payments. If the borrower can only make the minimum payment the unpaid interest gets deferred and added to the principal. This is known as ‘negative amortization’ and can cause the borrower to end up owing more than he or she borrowed at the end of the loan term. This can come as quite a surprise to a borrower who enters into an Option ARM and is not aware of the pitfalls. That is why the interest-only payment option should be the lowest payment the borrower should make unless absolutely necessary. The borrower will not have to worry about negative amortization as long as they pay at least the interest-only option amount or more.

If you enter into an Option ARM you must be able to maintain a high degree of financial discipline. You should also do your research and familiarize yourself with the ins and outs of Option ARM’s above and beyond what is included in this article. Your local mortgage broker, Company Name, is a good place to start. An experienced loan officer will be able to provide you with more in-depth information based on your credit score. Be sure to ask questions and compare other loan programs to your financing needs. Option Arm’s offer a high degree of financial flexibility but also bring with them a high degree of risk if used recklessly. The more you know about the ins and outs of Option ARM’s the better position you will be in to make a wise decision.