What Is an Option Adjustable-Rate Mortgage (Option ARM)?
Let me explain what an option adjustable-rate mortgage, or option ARM, really is. It's a type of ARM where you, as the borrower, get several options for the payments you make to the lender. Besides the standard payments of interest and principal like in conventional mortgages, option ARMs let you choose interest-only payments or even minimum payments that are much smaller.
You might also hear it called a flexible payment ARM.
Key Takeaways
An option ARM is basically a twist on the adjustable-rate mortgage, giving you the power to pick different payment options every month. These usually include a 30-year fully amortizing payment, a 15-year fully amortizing one, an interest-only option, or a minimum payment that doesn't even cover the full monthly interest.
To keep your debt from ballooning out of control, you have to be smart about which repayment structure you choose with an option ARM.
Understanding Option ARMs
Many option ARMs come with a low teaser rate, so you might refinance your current mortgage thinking you'll get lower payments. But watch out—once that short-term teaser expires, the interest rates jump back to levels like conventional mortgages.
If you're one of those who picks the minimum payment option, you'll see the principal on your mortgage actually increase. That's because those minimum payments don't cover all the interest, and the leftover gets tacked onto the principal.
These loans were big before the 2007-2008 subprime mortgage crisis, when home prices were skyrocketing. They had super-low introductory teaser rates, often just one percent, making people think they could afford bigger homes than their income allowed. But that teaser lasted only a month, then the rate reset to something like the Wells Cost of Saving Index plus a margin, hitting borrowers with payment shock. Since the 2014 regulations, option ARMs aren't as common anymore.
Ways Option ARMs Are Paid
Typically, with an option ARM, the lender lets you decide each month what kind of payment to make. Your choices might include a minimum payment, an interest-only payment, a fully amortized payment for a 15-year mortgage, or one for a 30-year mortgage.
Important Considerations
The Consumer Financial Protection Bureau effectively killed off option ARMs in 2014 with new Qualified Mortgage standards.
Sure, the flexibility in payments sounds good, but you could end up with way more long-term debt than you started with. Like other ARMs, interest rates can swing wildly based on the market.
Option ARMs might suit households with fluctuating income, like commission-based jobs, contracts, or freelancing. If work dries up, you could opt for the minimum payment to keep more cash on hand. But remember, that minimum can increase each year, and it might reset to a fully amortizing payment every five or 10 years.
Borrowers often miss these details, leaving them unprepared for rising costs and growing principal. If you keep making minimum payments and the unpaid balance exceeds the original mortgage—say, 110% or more—the loan could reset automatically.
These mortgages played a role in the housing crisis, where people used them for homes they couldn't afford, paid only the minimum, and then couldn't keep up as mortgages grew and home values dropped.
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