Option ARM (Adjustable-Rate Mortgage)

Definition

An Option Adjustable-Rate Mortgage (ARM) is a flexible mortgage that gives borrowers different monthly payment choices, allowing them to adjust their payments according to their current financial situation. The payment options usually include:

Fully Amortizing Payment: This payment covers both principal and interest, ensuring the loan is paid off by the end of the term.
Interest-Only Payment: This payment covers only the interest, leaving the principal unchanged.
Minimum Payment: This payment is less than the interest due, resulting in negative amortization (an increase in loan principal).

These loans are typically appealing to borrowers with variable incomes or uncertain financial scenarios. However, they also come with risks, such as the potential for payment shock when the loan recasts.

Examples

Arthur, the Freelance Writer: Arthur, who has inconsistent monthly income, opts for an Option ARM. Some months, he makes the minimum payment due to low earnings, which increases his principal balance. In better financial months, he opts for the fully amortizing payment to reduce his principal and interest.
Valerie, the Seasonal Worker: Valerie works in a job where her income spikes in the holiday season. She uses an Option ARM to make lower payments during her off months and switches to higher fully amortizing payments during peak season to manage her cash flow effectively.

Frequently Asked Questions

What are the advantages of an Option ARM?

Flexibility: Allows borrowers to adjust payments based on their financial situation.
Initial Lower Payments: Can offer lower initial payments compared to traditional mortgages.

What are the risks associated with an Option ARM?

Negative Amortization: Minimum payments can increase the principal owed.
Payment Shock: When the loan recasts, monthly payments can significantly increase.

How often can you change the payment option with an Option ARM?

Generally, borrowers can choose among the payment options each month, depending on their loan agreement.

Are Option ARMs suitable for everyone?

No, Option ARMs are best suited for those with fluctuating incomes or short-term plans to own the property. Long-term owners may face significant risks due to negative amortization and payment recasts.

How does an Option ARM compare with a fixed-rate mortgage?

Unlike fixed-rate mortgages, Option ARMs offer payment flexibility but come with the risk of increasing debt due to negative amortization.

Negative Amortization: An increase in the principal balance of the loan when the monthly payment is less than the interest due.
Fully Amortizing Payment: A loan payment method that covers both interest and principal, ensuring the loan is paid off by the end of the term.
Interest-Only Mortgage: A loan where payments cover only the interest, leaving the principal balance unchanged.
Payment Shock: A significant increase in monthly mortgage payments due to a recast or rate adjustment.

Online Resources

References

U.S. Government Accountability Office. (2022). “Mortgage Reform: Potential Impacts of Adjustable-Rate Mortgages.” Retrieved from https://www.gao.gov
Consumer Financial Protection Bureau. (2021). “Introduction to mortgage loan types.” Retrieved from https://www.consumerfinance.gov

Suggested Books for Further Study

“Mortgage Management for Dummies” by Eric Tyson and Ray Brown
“The Mortgage Encyclopedia” by Jack Guttentag
“All About Mortgages” by Julie S. Garton-Good

Real Estate Basics: Option ARM Fundamentals Quiz

### What is an Option ARM mortgage? - [ ] A loan with a fixed monthly payment for its entire term. - [x] An Adjustable-Rate Mortgage that allows the borrower to choose among several payment options each month. - [ ] A fixed-rate mortgage that automatically converts into a balloon payment. - [ ] An interest-free mortgage option available only to eligible people. > **Explanation:** An Option ARM is an adjustable-rate mortgage allowing flexibility for borrowers to choose among various payment options monthly—ranging from full amortizing, interest-only, to minimum payments leading to potential negative amortization. ### What is a key advantage of an Option ARM? - [x] Flexibility in payment options. - [ ] Guaranteed lower overall interest rates. - [ ] Faster repayment of the mortgage. - [ ] Fixed payments throughout the loan term. > **Explanation:** The primary advantage of an Option ARM is the flexibility it provides in payment options, allowing the borrower to adjust their monthly payments based on income or other financial circumstances. ### What risk does making the minimum payment on an Option ARM pose? - [ ] Immediate foreclosure. - [x] Increase in the loan principal due to negative amortization. - [ ] Higher upfront fees. - [ ] No risk involved in minimum payments. > **Explanation:** Making the minimum payment on an Option ARM can lead to negative amortization, wherein the unpaid interest is added to the loan's principal, thus increasing the principal over time. ### In what scenario might an Option ARM be most beneficial? - [ ] Fixed and predictable monthly income. - [x] Fluctuating monthly income. - [ ] Short-term cash reserves. - [ ] High credit scores only. > **Explanation:** An Option ARM is particularly beneficial for those with fluctuating monthly incomes, as it offers payment flexibility that can adjust with their varying earning capacities. ### What does the "interest-only payment" option in an Option ARM entail? - [ ] This option pays down both principal and interest. - [ ] It results in a pre-payment penalty. - [x] It covers only the interest, keeping the principal amount unchanged. - [ ] Payment based on future appraisal value. > **Explanation:** With the interest-only payment option, only the interest is paid, meaning the principal remains the same, preventing an increase in the mortgage balance but not decreasing it either. ### What is “payment shock” with respect to Option ARMs? - [ ] A sudden decrease in interest rates. - [ ] Requirement of a lump-sum payment after certain years. - [x] A significant increase in monthly payments when the loan recasts. - [ ] Upfront immediate fees are due on the first payment. > **Explanation:** Payment shock refers to the significant increase in monthly payments that can occur when the Option ARM loan resets, often to fully amortize the balance within the remaining term. ### When typically do Option ARM loans recast? - [x] At the end of a specified period, or when the negative amortization cap is hit. - [ ] Within one year of the loan being issued. - [ ] Only if default payments occur. - [ ] When house valuations change. > **Explanation:** Option ARM loans typically recast at predefined intervals, such as five or ten years, or when the outstanding balance hits the negative amortization limit. ### How do fully amortizing payments affect the loan balance over time? - [ ] Increases the loan balance. - [x] Decreases the loan balance by covering both interest and principal. - [ ] Keeps the loan balance unchanged. - [ ] Has no impact on the loan balance. > **Explanation:** Fully amortizing payments systematically reduce the loan balance since they cover both the accrued interest and part of the principal, aiming for complete repayment by the end of the term. ### What is a crucial consideration when opting for a minimum payment under an Option ARM? - [ ] Changes in property taxes. - [ ] Scheduled lender visits. - [ ] Fluctuations in nearby home prices. - [x] The potential for negative amortization. - [ ] Mortgage insurance premiums. > **Explanation:** Opting for a minimum payment under an Option ARM can result in negative amortization, where the principal increases due to unpaid interest getting added to the loan balance. ### Which type of borrower might generally avoid Option ARMs due to inherent risks? - [ ] Borrowers expecting windfalls - [x] Borrowers with fixed and predictable incomes - [ ] Seasonal workers - [ ] Entrepreneurs with varying monthly revenues > **Explanation:** Borrowers with fixed and predictable incomes may avoid Option ARMs due to the significant risks of payment shocks and negative amortization inherent to these loans, compared to more stable mortgage options.