An Option ARM mortgage is an adjustable rate mortgage that is packaged with four possible monthly payment options. Those options include an accelerated payment of principal and interest that will pay off the mortgage early; a standard principal-and-interest payment meant to pay off the loan over its thirty year life; an interest only payment; and a minimum payment that is even less than the monthly interest owed.

Like all ARMs, option ARM mortgages have attractive introductory rates well below the prevailing interest rate for fixed-rate loans. A low interest rate combined with an even lower minimum payment allows the borrower that chooses an option ARM the opportunity to maximize the size of the loan and buy a home that would otherwise be out of reach. It also presents the borrower with substantial risk.

A minimum payment schedule that allows for payment below the ARM interest rate will lead to negative amortization. What this means is that even though the borrower is making monthly payments, the mortgage debt is building because the payments do not match even the monthly interest due. While most option ARM mortgages have a cap on the annual rise allowed in the monthly payments due – often 7.5% – this cap does not protect the borrower from eventual loan adjustment that can lead to an enormous increase in the mortgage payment. These loans are “recast” every five or ten years so that the remaining payments are fully amortizing. That means a standard loan payment – principal plus interest – and the upward jump can be substantial.

The other prospect for an enormous increase in the monthly obligation emanates from the fact that most banks will only allow negative amortization to the point where the borrower owes 125% of the home’s value. At that point the loan is adjusted to account for the increased debt, also at a fully amortizing rate. This readjustment is also made regardless of the size of the monthly payment increase, and it can be an increase of overwhelming proportions.

Option ARMS are packaged in similar fashion as a standard ARM: when the interest rate is adjusted it is done by adding the index figure to the margin. An index is usually a money market figure drawn from some well known source such as a ten year Treasury note interest rate. The margin is the additional percentage points that are written into the mortgage contract as the final determinant of the loan’s interest rate for the adjustment period.

If you are choosing to take the risk of an option ARM, shop for the lowest margin as that is the factor that will impact the monthly payments most severely. The other obvious option is to maximize your monthly payment so that when adjustment does occur the sticker shock is minimized.…