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Option ARMs
Option ARMs
This type of Adjustable Rate Mortgage (ARM) gives the borrowers the "option" of what type of payment they would like to make for that payment period. This, in and of itself, creates a level of inherent risk that isn't present in Traditional Fixed Rate Mortgages. With an Option ARM Mortgage there are usually four payment options. These include:
- 15 Year Amortization - the highest monthly payment that amortizes the mortgage in 15 years.
- 30 Year Amortization - the second highest payment that amortizes the mortgage in the traditional 30 year time period.
- Interest Only - this option allows the borrower to make a payment equal to the interest of a 30 year amortized mortgage. The principal stays the same even though a payment was made.
- Minimum Payment - this payment option is less than the amount of interest due for that payment period. The additional amount owed in interest is added on to the principal, creating a higher loan balance than before the payment was even made!
At first glance an Option ARM seems like a scam. Borrowers are teased with low introductory interest rates and payments in exchange for higher rates later on and potentially higher principals as well. However, Option ARMs are a powerful financial tool for the right audience. First, Option ARMs offer a degree of flexibility not found in Traditional Mortgages. If, for some reason, money is tight during a given month a borrower has the option to pay a lower amount and not worry about incurring penalties or losing their home. Option ARMs are also beneficial for savvy investors. Some people knowingly get an Option ARM on property that is expected to rapidly increase in value. These same investors utilize the ability to make low payments and sell the property within the time frame they expected the value to increase. The increase in value ends up being more than what was paid in the interest only or negatively amortizing payment resulting in a profit.
Obviously, there is some inherent risk with an Option ARM Mortgage. For some people this is a catastrophe waiting to happen. When Option ARMs were first introduced borrowers began purchasing homes they otherwise couldn't afford. Although this seems like a great thing consider the downside. If a borrower can't even afford the 30 year payment option they are not amortizing their mortgage at all. This means that, at best, they are paying only interest. Worse case scenario they are making the minimum payments and the house is amortizing negatively, creating an even higher payment further down the road (potentially double what it would have been). This audience will suffer a high rate of foreclosure due to their inability to pay back the loan.
All said and done an Option ARM is intended mostly for savvy investors, those with irregular incomes (high yearly bonuses, commissions, etc.) or those who expect a large increase in income over the course of 1 to 2 years. Either way it's important to always understand the terms of any mortgage and understand the risks and potential pitfalls before they come about.