Mastering the Option Adjustable-Rate Mortgage (Option ARM): Flexibility with a Caution
An option adjustable-rate mortgage (option ARM) offers borrowers several payment options, providing unique flexibility in managing mortgage payments. Aside from standard interest-plus-principal payments like conventional mortgages, an option ARM allows for smaller payments through interest-only or minimal monthly payments.
An option ARM is also known as a flexible payment adjustable-rate mortgage.
Key Takeaways
- Option ARMs offer various monthly payment options, including a 30-year fully amortizing payment, a 15-year fully amortizing payment, an interest-only payment, or a minimal payment that might not cover the interest accumulated monthly.
- Effective management of payment choices is crucial, as opting repeatedly for minimum payments can substantially increase debt due to unmet interest being added to the principal.
Understanding Option ARMs
Many option ARMs offer initially low teaser rates, tempting borrowers to refinance existing mortgages for lower payments. Unfortunately, once these short-term rates expire, interest rates typically revert to higher conventional mortgage rates.
Borrowers who opt for minimum payments will notice an increase in their mortgage principal over time since the monthly payment might not cover all interest, which then gets added to the main loan amount. This mechanism often results in higher overall debt.
Option ARMs were popular before the subprime mortgage crisis of 2007-2008 due to their low introductory rates, making homes appear more affordable. However, resetting interest rates upon teaser period expiry often resulted in financial shocks for many. Regulatory changes in 2014 led to a decline in their popularity.
Payment Prospects with Option ARMs
Lenders allow monthly flexibility with Option ARMs, where borrowers can choose between various payment styles: minimum payments, interest-only payments, or full amortizing payments based on a 15-year or 30-year mortgage.
Since 2014, regulations by agencies like the Consumer Financial Protection Bureau (CFPB) have highlighted the potential risks associated with Option ARMs. While they provide payment flexibility suited for professionals with fluctuating incomes, like commission-based roles or freelancers, careful coordination is advised to avoid debt burden due to accrued unpaid principal and interest.
Rising payments and potentially increasing principal balances may surprise borrowers if not planned meticulously. If the mortgage balance surpasses the original loan value — reaching 110% or higher, for instance — the mortgage could reset, increasing payment burdens significantly.
Misunderstanding the escalated payments causes considerable financial distress, contributing notably to the housing crisis when mortgages exceed borrowers’ repayment capabilities, especially when housing values decrease.
Related Terms: ARM, Interest-Only Mortgage, Minimum Payment, Fully Amortizing Loan.
References
- Consumer Financial Protection Bureau. “Ability-to-Repay/Qualified Mortgage Rule”.
- Federal Deposit Insurance Corporation. “Crisis and Response: An FDIC History, 2008–2013”. Page 12.
