What is an adjustable-rate mortgage with options?

Adjustable-rate mortgage (ARM) with options is a type of adjustable mortgage that offers borrowers multiple repayment choices. Repayment options may include payments that apply only to interest and principal, interest-only payments, or paying a minimum amount due.

Definition and Examples of Adjustable-rate Mortgage with Options

An adjustable-rate mortgage with options is an adjustable mortgage featuring several repayment options. Option ARMs are no longer as common as they once were.

Understanding the basics of adjustable mortgages helps in comprehending option ARMs. Adjustable-rate mortgages allow buyers to pay a low fixed rate for a set period. After that initial period ends, the mortgage rate may adjust to align with the underlying index rate. For example, a 5/1 ARM has a fixed rate for the first five years. After that, the rate adjusts once annually until the loan is paid off.

With option ARMs, the lender can provide you with several possibilities for making payments toward the principal and interest on the loan. The option you choose can directly affect the speed at which interest and principal reduce on the loan.

For instance, suppose you have an option ARM, and the lender allows you to make payments only on the interest. When you make payments each month, these payments go toward the interest on the loan but do not affect the principal.

Note: Option adjustable-rate mortgages were effectively eliminated in 2014 when the Consumer Financial Protection Bureau (CFPB) introduced qualified mortgages.

How Option Adjustable-rate Mortgage Works

If you find a lender offering option ARMs, you may be able to take advantage of a flexible payment structure that allows you to determine how to repay the loan. You might find one of the following repayment options:

• Principal and Interest: This option resembles a traditional mortgage payment, where part of the payment goes toward interest and some toward principal. Payments can be due on a repayment schedule of 15, 30, or 40 years.
• Interest Only: Options adjustable-rate mortgages allow payments only on interest. In this case, payments will apply to interest on the loan and not to the principal for a certain period. After that period, your monthly payment will increase – even if interest rates remain stable – because you’ll have to start repaying principal alongside interest each month.
• Minimum or Limited Payment: This third option allows you to pay a minimum amount that may be less than the interest due on the loan.

Generally, option ARMs have low-interest rates for the initial few months. So you might pay 1% or 2% on the loan initially, then see those rates adjust. The monthly payments you make during the first year are based on the initial interest rate. So if you choose the minimum or limited payment that does not cover the interest, the unpaid interest will be added to the loan balance, increasing both the loan balance and the interest you will eventually pay.

This situation is called negative amortization. Simply put, it means that even as you make payments toward the loan, the balance will not decrease if those payments do not cover the interest. Negative amortization can be problematic, as it may result in owing more on the mortgage than the home is actually worth.

Can

For option adjustable-rate mortgages, there is a cap on how much your monthly payment can increase year over year. Typically, your loan payments are recalculated every five years, based on the remaining term of the original loan. However, the payment cap does not apply to these adjustments.

Note: The lender may terminate optional payments if the loan balance exceeds a certain limit due to negative amortization.

Criticism of Option Adjustable-Rate Mortgages

Option ARMs are designed to attract buyers who desire flexible repayment options. In the mid-2000s, more mortgage lenders began marketing option ARMs as a low-rate option for borrowers. By 2006, option ARMs accounted for 9% of the total mortgage market.

The problem with option ARMs lies in their structure. For instance, making only interest payments means that nothing is applied to the principal of the loan, so your loan balance does not decrease. While your monthly payment rate can increase when the interest rate adjusts, you are not making progress on what you owe.

At the same time, the minimum payment can increase the loan balance if you are paying less than the interest each month. Think of it like making the minimum payment on a credit card. You may always pay $50 a month, but if the interest charges are $100 a month, you are essentially not making any progress.

Option ARMs, alongside other subprime mortgages such as no-documentation loans and fraudulent loans, came under close scrutiny following the 2008 crisis. As a result, lenders began pulling back on offering them. For example, Wachovia bank decided to stop offering option ARMs in 2008. However, this did not prevent the bank from being targeted in a class-action lawsuit related to option ARMs, which resulted in a $627 million settlement.

Nowadays, option ARMs have nearly disappeared from the mortgage market. However, lenders can still offer interest-only mortgages, where payments are made toward interest only for a limited period. Remember that making interest-only payments does not reduce your loan balance.

If you have an interest-only loan or an ARM, consider refinancing to a fixed-rate loan at a low rate that might save you money.

Source: https://www.thebalancemoney.com/what-is-an-option-adjustable-rate-mortgage-5206355