"Option ARM Explained" 

"Option ARM Explained"

Benefits and disadvantages of Option ARMs

An "option ARM" is a loan where the borrower has the option of making either a specified (1) minimum payment, (2) an interest-only payment, (3) a 15-year or (4) 30-year fixed rate in a given month. The minimum payment is less than an interest-only payment and therefore results in negative amortization, while the full payment is the fully-amortized share of interest and principal.

Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called "teaser rate") and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible.

Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. With a fixed-payment loan, if they were unable to meet the payment during their lean season they would risk late fees or foreclosure.

The main risk of an Option ARM is "payment shock", when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance. Another risk, as with any loan with potential negative amortization, is that the increased loan balance will reduce or eliminate the borrower's equity in the financed property, or if the value of the property declines, make it impossible to sell the property for an amount that will repay the loan.

The option ARM loan program is an adjustable rate mortgage with added flexibility of making one of several possible payments on your mortgage every month, in order to better manage your monthly cash flow. It's low introductory start rate (usually between 1% to 1.95%) allows you to make very low initial mortgage payments and low qualifying rates enable you to qualify for a bigger mortgage.

The minimum payment option can help keep your monthly payments affordable. If the minimum monthly payment is not sufficient to pay the monthly interest due, you can always avoid deferred interest by choosing the interest-only payment option.

With the Option ARM, you generally have at least two fully amortized payment choices, leading to a quicker loan payoff. If you prefer to pay off your loan on schedule, you can make the fully amortized payment based on a 30-year loan, or you can choose the 15-year payment option for the fastest equity build-up.

Option ARM loans have 4 major types of payment options:

Minimum Payment

With the minimum payment option, your monthly payment is set for 12 months at your initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year.

If you make the minimum payment after the end of your initial interest rate period, which holds only for the first month, it may not be enough to pay all of the interest charged on your loan for the previous month and the unpaid interest will be added to the principal balance you owe (will be deferred).
 
Interest-Only Payment

The interest-only payment may change every month based on changes in the ARM index used to determine your fully indexed rate. The option to pay 'interest-only' lets you pay only the interest portion of your monthly payment for a fixed period. At the end of that period your loan becomes fully amortized, thus resulting in greatly increased monthly payments. Your new payment will be larger than it would have been if it had been fully amortizing from the beginning. The longer the interest only period, the larger the new payment will be when the interest only period ends.

Fully Amortizing 15-Year Payment

If you prefer to put your loan on an accelerated schedule and can afford higher monthly payments, the 15-year payment option allows you to repay your loan twice as faster and save more than half the total interest costs of a 30-year loan.
 
Fully Amortizing 30-Year Payment

With fully amortizing payments, you pay both principal and interest and keep your loan on schedule. Your payment is calculated each month based on the prior month's fully indexed rate, loan balance and remaining loan term.
 
These 4 options should be clearly marked on your loan statement, so it is very easy to figure out how much you should pay each month. Just enter the correct amount in the payment coupon section of your statement.

Option ARM loan programs may vary in the initial rate, negative amortization and lifetime caps, ARM index, or optional features, however, when comparing one option ARM with another, pay close attention to the margin and the fully indexed rate. Keep in mind that the initial interest rate holds only for the 1st month.

What features to compare with different Option ARM loans?

Your 'Start Rate' may vary from 1.00% up to 1.95%. Initial Interest Rate Period (Introductory Period, Initial Fixed-Rate Period)
Option ARM loans are available with an initial introductory period, usually of 1, 3 or 6 months, after which the interest rate may change.

With 1-month option ARMs that have a 1-month introductory period, the first interest rate change occurs when the 1st monthly payment is due. Thereafter, the interest rate may change monthly. 

If you have a 1-month option ARM loan with a 3-month introductory period, the first interest rate change occurs when the 3rd monthly payment is due. Subsequent interest rate changes may occur each month thereafter.

Minimum Payment

Minimum Payment Adjustment Period

The minimum payment adjustment period is usually set to 12 months, unless negative amortization limit (set by lender) is met.

Minimum Payment Change Cap

A limit on how much the minimum monthly payment can change at each adjustment. With most option ARMs, your payment cap will be 7.5% of minimum payment amount in first five years. It means that on any Payment Change Date, the minimum payment cannot increase or decrease by more than 7.50%

Payment Recast Period

Recasting is another way of limiting negative amortization and keeping your loan on the original schedule. The main purpose of recasting is ensure the loan is paid off within the scheduled amortization period. Option ARM loans are usually recast every five or ten years (or sooner, if the negative amortization limit is met).

 

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