An option ARM is an adjustable rate mortgage with a twist. It offers the lower interest rate benefit of a standard adjustable rate mortgage while allowing borrowers to choose how much they want to pay each month. From minimum payments as low as 1%, to interest only payments, fully-amortized 30 year payments, or accelerated 15 year payments. Borrowers can tailor their payments to accommodate economic necessities and lifestyle choices as they manage their mortgages.
The Option allows the use of equity in the home to keep the payments low when needed. If rates drop or income increases borrowers can elect to accelerate the payoff with a 15 year amortized payment. Those expecting a windfall like an inheritance or legal settlement can choose to pay down the balance. Some lenders will even recalculate or recast the loan (changing all four payment amounts) based on the new balance if the borrower chooses.
Other available enhancements are 40 year terms and no income verification (NIV) options. The 40 year amortization lowers the fully amortized payment and may add a layer of safety for borrowers. NIV means no income verification is required, and it is used when borrowers' incomes are hard to verify--for example self-employed people or those with very complicated finances they prefer to keep private.
Caps are among the most important features of an Option ARM. Most loans have rate caps, and lower caps are better than higher caps. Option ARM caps come in two guises--payment caps and lifetime rate caps. The payment cap, generally 7.5%, kicks in each year when the minimum payment is adjusted upwards. For example, a $300,000 loan with a 1% minimum payment rate would begin with minimum monthly payments of $758.57. After a year, the payment would adjust a maximum of 7.5% to $815.46, and the next year to $876.62. This protects borrowers from sudden, perhaps unaffordable increases.
The other cap is a lifetime rate cap, or ceiling. It is usually expressed as a maximum rate and can vary from 9% to 19%, depending on financial markets at the time the loan is taken out. Knowing the maximum loan rate helps borrowers plan accordingly.
Disadvantages: Borrowers who make extensive use of the minimum payment option could rapidly erode the equity of their homes and even end up owing more than the house is worth. For example, the 1% minimum payment on a $300,000 loan is $758.57 the first year, but if the loan's actual rate is 5.25% it takes a payment of $1,312.50 to cover the interest owed. So borrowers who make the minimum payment will not be paying their mortgages down; instead, the balance will increase each month--in this case by $553.63. Eventually, that money has to be repaid and to accomplish this, the loan will be recast--possibly with very high payments to make sure it is repaid within the 30 year term.
Advantages: Option ARMs are considered sophisticated instruments that should not be jumped into lightly. They benefit borrowers who intentionally opt for a lower payment to achieve short term financial goals, not to sustain an unaffordable lifestyle over the long haul. Here are some examples of borrowers who could successfully use an Option ARM:
- Recent graduates in high-paying fields like medicine can buy a nice house, make the minimum payment until the income kicks in, then play catch up by making larger payments when they can afford to.
- Borrowers with good but sporadic income, like successful salespeople or owners of seasonal businesses can pay more when flush and less when money is tight.
- Those expecting a windfall, such as an inheritance or legal settlement, might buy their home and pay the minimum until the money comes in. Then, they can make a large payment to reduce the principal balance of their mortgage.
- Some borrowers are savvy investors, and get funds to invest by directing money from mortgage payments to investments. Eventually some of the investment profits will be used to repay the mortgage.
Option ARMs have an upside and a downside. If borrowers understand them and use them correctly, they can enrich both lifestyles and investment strategies. Income stability, tolerance for risk, and future plans all affect the choice of an Option ARM. Those who can't withstand a huge payment increase should consider more stable loan offerings.