What Is a Flexible Payment ARM?

A flexible payment ARM, also known as an option ARM, was a type of adjustable-rate mortgage (ARM) 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 that 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.

Key Takeaways

  • A flexible payment ARM was a type of adjustable-rate mortgage that allowed a borrower to select from four different payment options each month.
  • The payment options included a 30-year mortgage, a 15-year mortgage, an interest-only mortgage, and a minimum-payment mortgage.
  • Most of these mortgages started with a low introductory rate then shot up to a higher interest rate, leaving the borrower with "payment shock" and often with the inability to pay the new monthly payments.
  • Flexible payment arms played a role in the subprime meltdown that led to the 2008 financial crisis as borrowers began to default on their loans.
  • The CFPB established its Qualified Mortgage program in 2014, granting certain types of mortgages QM approval, which flexible payment arms did not receive, eventually rendering them obsolete.

Understanding a 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%, which led many people to assume that they could afford a more expensive 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. This in effect increased the size of the loan. When home prices collapsed, borrowers found they owed more on their mortgages than their homes were worth.

Homeowners could not sell their homes, as the value was too low, and many borrowers could not afford to make monthly mortgage payments, leading to defaults that spread through the banks and any financial mortgage products, such as mortgage-backed securities (MBS).

Disuse of the Flexible Payment ARM

Flexible payment arms and other option ARMs 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% to 115% 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.

Many of these mortgages were written by predatory lenders who were more interested in closing a deal and making a commission as opposed to the possible negative financial impact it would have on borrowers, knowing that they might eventually not be able to afford their mortgages.

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.