Flexible Payment ARM

What Was a Flexible Payment ARM?

A flexible payment ARM was a type of adjustable-rate mortgage (ARM) that allowed the borrower to select from different payment options each month. Common in the early 2000s, they made it possible for many people to get home loans, but their lax standards helped contribute to the subprime mortgage meltdown of 2007–2008.

The Consumer Financial Protection Bureau (CFPB) effectively eliminated flexible payment ARMs in 2014 through its Qualified Mortgage (QM) standards.

How Flexible Payment ARMs Worked

Also known as an option-payment or option ARM, flexible payment ARMs typically offered four different payment options:

• A 30-year, fully amortizing payment;
• A 15-year, fully amortizing payment;
• An interest-only payment;
• A so-called minimum payment that did not necessarily cover the monthly interest.

Borrowers could vary the payment option that they used from month to month.

The interest rate on the ARM was typically very low for the first one to three months; after that, it would reset to something more competitive. There was usually a limit, or cap, on the amount that the monthly minimum payment could increase from year to year. The mortgages also featured a built-in recalculation period, usually every five years, when the payment would be recalculated based on the remaining term of the loan.

History of Flexible Payment ARMs

Flexible payment ARMs were popular before the subprime mortgage crisis of 2007–2008. In fact, their popularity may well have helped trigger the crisis.

In the late 1990s and early 2000s, home prices rose rapidly. People were eager to own and invest in real estate, and flexible payment ARMs made it easy for them to do so.

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 often was only for one month. Then the interest rate reset to an index such as the Wells Fargo Cost of Savings Index (COSI) plus a margin.

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—even though it was higher than the teaser rate—still seemed like a great deal.

Many borrowers did not understand that, by paying only the monthly minimum, the unpaid interest would be tacked on to the loan balance, a process called negative amortization. In effect, this increased the size of the loan. When home prices began to collapse in 2007, borrowers found that they owed more on their mortgages than their homes were worth.

Homeowners could not sell or refinance their homes, as the value was too low. And as interest rates began to rise, many borrowers could not afford to make the monthly payments on their mortgages, leading to defaults that spread to many financial products, such as mortgage-backed securities (MBS), that were based on these loans. Banks, investment firms, and others that had invested heavily in these products faced crushing losses and insolvency in turn.

Risks of Flexible Payment ARMs

Flexible payment ARMs had a lot of fine print that borrowers often glossed over. For example, many didn’t really get the negative amortization concept—the fact that by paying only the monthly minimum, they could actually be increasing the size of their debt. Another often-overlooked detail: Making minimum payments couldn’t go on forever. Most option-payment ARMs had a negative amortization cap, meaning that the borrower could only make minimum payments until the loan value reached 110% to 125% 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 10 years. Many homeowners saw their loan payments more than double after just a few years.

The End of Flexible Payment ARMs

People who opted for these loans may have been irresponsible, greedy, or financially careless. But they were also victimized to some extent. Many flexible payment ARMs 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 that it would have on borrowers. They approved people for loans, knowing that those people weren’t really qualified (by traditional underwriting standards) and eventually might not be able to afford their mortgages.

To discourage banks from writing loans that could potentially bankrupt homeowners, the CFPB established its Qualified Mortgage (QM) 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 negatively amortizing loans like flexible payment ARMs were never granted QM approval, banks largely abandoned them in favor of more conventional ARMs and fixed-rate mortgages. 

The Bottom Line

Until 2014 when it was effectively eliminated by the Consumer Financial Protection Bureau (CFPB), borrowers could choose a type of adjustable-rate mortgage (ARM) that allowed them to choose from among four different payment options each month. These mortgages were common in the early 2000s and made it possible for many people to get home loans, but lax standards in mortgage issuance helped contribute to the subprime mortgage meltdown of 2007–2008. Flexible payment ARMs are no longer available in the United States.