Legal Definitions - Option ARM

An Option ARM, which stands for Adjustable-Rate Mortgage, is a type of home loan that offers borrowers several different payment choices each month. Unlike a traditional fixed-rate mortgage or even a standard adjustable-rate mortgage where payments are typically set to cover both principal and interest, an Option ARM provides flexibility in how much the borrower pays.

The common payment options available to a borrower with an Option ARM include:

• A fully amortizing payment: This payment covers both the interest accrued and a portion of the principal balance, similar to a conventional mortgage. Making this payment choice will gradually reduce the total amount owed on the loan over time, typically over a 15-year or 30-year term.
• An interest-only payment: This option allows the borrower to pay only the interest that has accumulated on the loan for that month. While this results in a lower monthly payment, it does not reduce the principal balance of the mortgage. The amount owed on the home remains the same.
• A minimum or limited payment: This is the lowest payment option and often does not even cover the full amount of interest due for the month. When a borrower chooses this option, the unpaid interest is added to the loan's principal balance. This process is known as negative amortization, meaning the total amount the borrower owes on the mortgage actually increases over time, rather than decreases.

Option ARMs were more prevalent in the mortgage market prior to the 2007-2008 financial crisis, particularly as a type of subprime mortgage, due to the risks associated with negative amortization and potential payment shock when the loan "recasts" to a fully amortizing schedule.

Examples of Option ARM in Practice:

• Example 1: Young Professional Seeking Initial Flexibility

  Sarah, a recent medical school graduate, purchases her first home. She anticipates her income will significantly increase over the next few years but wants to keep her initial housing costs low while she pays off student loans. She chooses an Option ARM, initially making the interest-only payment. This allows her to manage her budget effectively in the short term. She understands that while her principal balance isn't decreasing, she can switch to a fully amortizing payment once her income stabilizes, or even make extra principal payments when she has surplus funds.

  Explanation: This illustrates an Option ARM because Sarah has the choice to make an interest-only payment, providing her with immediate financial flexibility. She is not required to pay down the principal initially, which is a key feature of this type of mortgage.

• Example 2: Homeowner Facing Temporary Financial Hardship

  Mark loses his job unexpectedly and needs to drastically reduce his monthly expenses for a few months while he searches for new employment. He has an Option ARM and decides to make the minimum payment for three consecutive months. During this period, the portion of the interest he doesn't pay is added back to his loan's principal balance. Although his monthly outflow is very low, his total mortgage debt slowly increases.

  Explanation: This scenario demonstrates the minimum payment option of an Option ARM, which leads to negative amortization. Mark's principal balance grows because his payments are not even covering the full interest due, highlighting the potential long-term financial impact of this choice.

• Example 3: The "Recast" and Payment Shock

  Ten years ago, Lisa took out an Option ARM, consistently making the minimum payment to keep her monthly expenses low. Over time, her principal balance grew significantly due to negative amortization. Now, her loan has reached its "recast" point, a pre-defined trigger where the mortgage automatically adjusts to a fully amortizing payment schedule to pay off the increased principal balance over the remaining loan term. Her monthly payment suddenly jumps from $1,200 to $2,500, creating significant financial strain.

  Explanation: This example illustrates the long-term consequences of consistently choosing the minimum payment option with an Option ARM. The initial flexibility eventually leads to a much higher payment when the loan "recasts" due to the accumulated negative amortization, demonstrating the inherent risk and eventual payment shock associated with this mortgage product.