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Option Adjustable Rate Mortgages

This is a type of adjustable rate mortgage. Like all adjustable rate mortgages, the interest rate is fixed for a period of time and then it can go up or down. “Option ARM” stands for “option adjustable rate mortgage.”

What’s different about option ARMs is that every month you have four payment options. This gives you more flexibility to decide how much you are going to pay, and it can make the loan more affordable. The problem is, it can be tempting to just pay the minimum. If you do this, the amount you owe will increase, and you will lose equity in your home. You could even end up owing more than your home is worth!

The other risk with the minimum payment is that after the first few years you payments can increase a lot – they could double or even triple. The EverydayMoney Mortgage Tool can help you estimate your payments for an option ARM. The four payment options for an option ARM are:

  • Minimum payment: a low payment, usually between 1% and 2%. Even though the payment is so low, the actual interest rate on your mortgage is higher. If you just pay the minimum, your mortgage will get bigger and you will lose equity in your home. This is called “negative amortization.”
  • Interest-only payment: this is larger than the minimum payment. It pays the monthly interest on the mortgage. The size of your mortgage stays the same if you pay the interest. See interest-only mortgage for more information.
  • Fully amortizing 30-year payment: this is the payment that would pay off the mortgage in full in 30 years. It is larger than the interest-only payment because you are also paying principle. With this payment, the size of your loan will decrease and you will have more equity in your home.
  • Fully amortizing 15-year payment: this is the payment that would pay off the mortgage in full in 15 years. It is the largest payment option. With this payment, the size of your loan will decrease the most.

Most option ARMs place limits on how much your payments can increase. For example, the minimum payment usually cannot increase by more than 7.5% per year. However, if you pay just the minimum payment for a long time, your loan can grow a lot. Usually, when your loan grows to 125% of its original size, your minimum payments will jump up. This is called a “negative amortization cap.”

Option ARMS are very complicated. If you are going to get an option ARM, try to understand it as well as you can, and use the EverydayMoney Mortgage Tool to estimate what your payments might be. Low payments for a few years can be great, but if you are going to stay in your home for a long time, your payments will eventually increase a lot. Plan ahead to avoid putting yourself in a tight spot.