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To understand what an Option ARM mortgage is, it is important to first understand what an adjustable rate mortgage (ARM) is.  Put simply, an ARM is a loan that has a fluctuating interest rate.  This interest rate is typically determined by the “London Interbank Offered Rate (or LIBOR for short)” which is a rough measure of most banks’ cost of funds.  The interest rate on an ARM is typically a few percentage points higher than the LIBOR, which can range from as low as 1-2% to as high as 10%%.  As you can imagine, this makes the interest rate, and thus the average monthly payment, on an ARM extremely difficult to predict.  The upside is that an ARM is a very cheap loan when interest rates are low.  However, when interest rates are high, the monthly payments on an ARM can rise dramatically.

Option ARM mortgages add another layer of complexity to the standard ARM.  With an option ARM mortgage loan, the borrower can choose what “type” of payment they wish to make every month.  The choices, in order from smallest to largest, include a minimum payment, an interest only payment, a payment calculated by a 15 year amortization schedule, or a payment calculated by a 30 year amortization schedule.  The size of these payments are determined by the current level of interest rates in your country.  Here’s a simple explanation of each payment type:

Minimum Payment

A minimum payment is typically about one half to two thirds of the accrued interest on an ARM.  This means that, for a typical $200,000 loan, your minimum payment may only be about $1,000.  Please note though that there is a definite cap to the number of minimum payments you can make.  The cap will depend on the terms of your loan, but its parameters are clearly defined.  Some loans allow you to make minimum payments for six months to three years.  The other cap is determined by something called the “negative amortization level.”  When you make a minimum payment on an option ARM, it is typically much lower than even the amount of interest that has accrued over the month.  The difference between the minimum payment and the accrued interest is then added to the loan’s balance, which is called negative amortization.  Most option ARMs have a negative amortization cap of 110%, which means you are only able to utilize minimum payments until your loan’s balance has reached 110% of the original principal.  It does not take very many minimum payments to reach this cap.  With moderate interest rates, it typically takes a year to reach your negative amortization cap.  Because of this, borrowers who hold an option ARM should try, if at all possible, to avoid making minimum payments.

Interest Only Payment

This is a very cut and dry payment.  It is simply a payment of the interest that has accrued over the course of the payment period.  The cost of the interest only payment can vary by a lot due to fluctuations in the national interest rate, so be wary of economic trends.  Most option ARMs only allow you to make interest only payments for ten years, at which point you will have to make true amortized payments.

Amortized Payment

This is a payment that is based on the amortized interest + principal over the course of either 15 or 30 years.  This payment can and will be dramatically higher than either a minimum payment or an interest only payment because it is taking the loan’s principal into account.  Also, this payment is re-calculated every month depending on the LIBOR.

When you hear in the news about option ARMs “resetting,” what the news anchors are typically referring to is borrowers being forced to make amortized payments.  There are a great deal of risks involved with using an option ARM.  Aside from fluctuating interest rates (which can sometimes double or even triple monthly mortgage payments on its own), option ARMs also naturally, due to negative amortization, increase the base level of risk in holding a mortgage.  When you make a minimum payment on an option ARM, you are literally reducing the equity in your home because your mortgage’s principal is increasing.  An economic  environment with falling housing prices and rising interest rates can be absolute disastrous to holders of option ARMs

So then, who should actually seek out an option ARM?

It only makes economic sense for somebody with a quickly growing income to seek an option ARM.  For example, a junior trader at an equity firm or a first-year accountant can expect to have a rapidly rising income.  The way an option ARM is structured, payments are very low in the beginning and become very high over time.  Only those who can expect quick pay raises should seek an ARM.

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