DEFINITION of Payment Option ARM
A payment option ARM is a monthly adjusting adjustable-rate mortgage (ARM), which allows the borrower to choose between several monthly payment options, including the following:
- A 30 or 40-year fully amortizing payment
- A 15-year fully amortizing payment
- An interest-only payment
- A minimum payment or a payment of any amount greater than the minimum
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.
Caveats of Payment Option ARMs
In order to avoid substantially increasing the amount of debt that is owed on a mortgage, the borrower must carefully choose the repayment structure he/she wants to adopt with a payment option ARM. While popular in the lead up to the mortgage crisis, payment option ARMs later drew criticism. The nature of this type of mortgage allowed for borrowers to make smaller payments, which they believed they could accommodate, but the overall debt on the mortgage continued to grow rather than decreasing the balance.
After the mortgage crisis struck, it came to light that some lenders offered payment options ARMs to borrowers who otherwise did not qualify to purchase the homes they were using this financing for. Although these mortgages could cover the sale prices of the homes – the way the debt could escalate if the borrower did not pay off the interest as well as reduce the principal balance meant that inevitably – borrowers who could not afford the debt would go into default.
There are benefits to payment option ARMs, particularly for real estate speculators looking to make short-term investments in property, especially if they intend to refurbish and put the property back on the market in short order.