What is a Flexible Payment ARM

A flexible payment ARM, also known as an option ARM, was a type of adjustable-rate mortgage that allowed the borrower to select from four different payment options each month: a 30-year, fully amortizing payment; a 15-year, fully amortizing payment; an interest-only payment or a so-called minimum payment which did not cover the monthly interest. The Consumer Financial Protection Bureau (CFPB) effectively eliminated flexible payment ARMs in 2014 through new Qualified Mortgage (QM) standards.

BREAKING DOWN Flexible Payment ARM

Flexible payment ARMs were popular before the subprime mortgage crisis of 2007-2008, when home prices rose rapidly. The mortgages had a very low introductory teaser interest rate, typically 1 percent, which led many people to assume they could afford more home than their income might suggest. But the teaser rate was only for one month. Then the interest rate  reset to an index such as the Wells Cost of Saving Index (COSI) plus a margin, often resulting in “payment shock.”

Using the new interest rate, borrowers could choose to make a conventional 30-year mortgage payment or an even larger, accelerated 15-year payment. In practice few borrowers did this; after the first month, most opted for either the interest-only payment, or the minimum monthly payment, which seemed like a great deal. Many borrowers did not understand that the unpaid interest would be tacked on to the loan balance, a process called negative amortization. When home prices collapsed, borrowers found they owed more on their mortgages than their homes were worth.

The Details Tripped Up Many Homeowners

Option ARMs also had a lot of fine print that many borrowers glossed over. For example, most option ARMs had a negative amortization cap, meaning the borrower could only make minimum payments until the loan value reached 110-115 percent of the original amount. Minimum payments also increased annually, sometimes by percentages that didn’t seem like much but compounded quickly. And the interest-only payment option was usually only good for the first ten years. Many homeowners saw their loan payments more than double after just a few years.

To discourage banks from writing loans that could potentially bankrupt homeowners, the CFPB established its Qualified Mortgage program in 2014. Under this program, certain types of stable mortgages would gain the agency’s QM approval and qualify the issuing bank for greater protection in the event of default. Since negative amortization loans like flexible payment ARMs were never granted QM approval, banks largely abandoned them in favor of more conventional ARMs and fixed-rate mortgages.