What exactly is an Option ARM?

Hybrid Adjustable Rate Mortgage - An ARM is a type of mortgage in which the rate of interest charged on the borrowed amount varies based on an underlying index rate. As the underlying index rate varies, so does the monthly payment amount on the mortgage. In general, an ARM allows a borrower to obtain a mortgage with an interest rate that is usually lower than a fixed-rate type of mortgage, at least at the beginning. The interest rate is usually some fixed amount above an index rate, such as the "cost of funds" rate. As the index rate changes, so does the interest rate on the ARM.

This type of ARM is especially good if you are going to be in your home for only a few years. You get a lower interest rate during that time and can plan to sell before the monthly payment resets.

Example to make it clear : A Hybrid Arm Vs. a 30-Year Fixed Mortgage

If you borrowed $250,000 with a 30-year fixed-rate mortgage at 6.5%, your monthly payments would be $1,580.17 for the lifetime of the loan. If, on the other hand, you get a hybrid ARM at 4% for five years and an indexed rate for the remainder, your first 60 monthly payments would only be $1,193.54. They would then change yearly as the interest rate resets each year. If, for instance, the new rate at the start of year six is 8%, then the payment would become $1,745.22. This payment could change up or down, depending on the movement in the indexed rate.

Option ARM - This is a type of mortgage that can offer various payment options ranging from a minimum payment option, which is usually less than the monthly interest due, to an accelerated payment option, which will cut down on the term of the mortgage.

This type of loan is best for people who want the low monthly payment to start, but can afford a much higher monthly payment. It also is good for those who will move out before the ARM resets.

Example - Option ARM Payment Scenario

Suppose you borrowed $250,000 with a low teaser rate of 1.5%. Your initial minimum monthly payment would be only $862.80 - very affordable. But, the fully amortized payment at the loan's indexed rate of, say, 6.2% would have been $1,531.17, so the difference of $668.37 is added to your mortgage's principal every month. In the second year, the terms of your loan might cause the minimum payment to increase slightly to $927.51, but the amortized amount is now $1,659.40 because the indexed rate has gone up to 6.56% - and now $731.89 is being added to the balance each month. By the time Year 5 rolls around, you could be paying a minimum of $1,071.85, while the loan's indexed rate has increased to 8%, and you are adding some $940 a month to the principal. Not too bad, so far, but at some point, you've got to start paying down that principal. The bank, after all, wants its money back.

This is where Year 6 comes in and the option ARM resets. Thanks to making only the low minimum payments, you would owe almost $300,000 instead of $250,000. At 8%, monthly payments for the remaining 25 years will be $2,312.10, more than twice what you were paying in Year 5 and almost three times what you paid in Year 1. Ouch!

This type of loan is best for people who want the low monthly payment to start, but can afford a much higher monthly payment. It also is good for those who will move out before the ARM resets.

Now read about the real problem with Option ARM here