DEFINITION of 'Payment Option ARM'
A monthly adjusting adjustable-rate mortgage (ARM) which allows the borrower to choose between several monthly payment options: a 30 or 40-year fully amortizing payment, a 15-year fully amortizing payment, an interest-only payment, a minimum payment or any amount greater than the minimum payment.
The minimum payment option is calculated based on an initial temporary start interest rate. While this temporary start interest rate is in effect, this is the only payment option available. It is a fully amortizing payment. After the temporary start interest rate expires, the minimum payment amount remains a monthly payment option; however, whenever a payment is made which is less than the scheduled interest-only payment, deferred interest is created.
BREAKING DOWN 'Payment Option ARM'
Payment option ARMs have a great deal of payment-shock risk. The monthly payments might increase for several reasons, including an unscheduled recast when a negative amortization limit is reached. The fully indexed interest rate is important in this calculation. The rate of negative amortization is a function of the interest-only payment (based on the fully indexed interest rate) and the minimum payment. If the fully indexed interest increases substantially, the rate of negative amortization increases when the minimum payment is made, increasing the likelihood that the negative amortization limit will be reached and the mortgage will recast.