How Does an Option ARM Loan Work?

Option ARM (also called Pick A Payment or Pay Option ARM) loans work by providing the borrower with four payment options each month.

Before we get into the payment options, let's review some of the important terms and concepts involved with this loan program.

ARM - Adjustable Rate Mortgage. An ARM is a mortgage whose interest rate is raised or lowered at periodic intervals according to the prevailing interest rates in the market. Also called variable-rate mortgage.

Principle - The original amount of money provided in a loan is the principle. This amount, plus the interest accrued must be paid back in full by the end of the loan's term.

Interest - Interest is the cost paid to borrow the money.

Start Rate - The initial rate of the mortgage. This rate is the rate that the minimum payment option is based on. Typically this rate will range from 1-2%.

Amortization - The process of paying down the principle balance of a loan. A fully amortized loan is a loan that will be paid off completely through the monthly payments by the end of the loan's term.

Negative Amortization - Negative Amortization or neg am is the process of adding unpaid interest to the principle balance of the loan. If you make a minimum payment, the difference between that payment and the interest only payment will be added to the principal balance of your loan.

Index - An index is a measure of a particular security or other monetary instrument that can be used to adjust interest rates. Index examples include US Treasury Bond valuations, LIBOR (London Inter Bank Offering Rate), COFI (Cost of Funds Index), and MTA (Monthly Treasury Average). Indexes can adjust on a daily basis.

Margin - Margin is the difference between the Index and the rate on a loan.

Fully Indexed Rate - The fully indexed rate is calculated by adding the Index to the Margin. For example, if Libor was 3.0% and the margin on the loan was 2%, the fully indexed rate would be 5% (Index + Margin). The fully indexed rate is the rate that your loan accrues interest at.

Now that we've covered the basic terms, let's examine the four payment options

These payment options are:

1) Minimum Payment

This payment is a 30 year amortized payment based on the start rate of the loan. When the minimum payment is made, the difference between the minimum payment and the interest only payment is added to the principle balance of the loan.

This payment is lowest possible payment and lets you keep more cash in your pocket each month. This payment typically changes annually and is recalculated based on the remaining principal balance of the loan, the remaining loan term, and the current interest rate. A payment cap is usually applied to ensure that they payment does not swing wildly from year to year. A typical payment cap is 7%. For example, if your minimum payment was $1,000 in year one, the most it would be in year two is $1,070 and the least it would be is $930.

2) Interest Only Payment

This payment is based on the fully indexed rate. These payments do not pay down the principal balance of the loan.

In order to avoid deferred interest and negative amortization, each month you will be given the option to make an interest only payment. This allows you the benefit of keeping a low monthly payment and keeps the principal balance of your loan at the same amount.

3) 30 Year Fixed Payment

This payment is based on the fully indexed rate. These payments do pay down the principal balance of the loan.

It's calculated each month based on the prior month's interest rate, loan balance and remaining loan term. When you choose this option, you reduce your principal and pay off your loan on schedule.

4) 15 Year Fixed Payment

ly indexed rate. These payments do pay down principal balance of the loan.

If you want to build equity faster, pay off your loan quicker and save on interest, this is the option for you. It's calculated to amortize your loan based on a 15-year term from the first payment due date.

Let's take a look at a couple of examples.

Example 1:

$250,000 Loan Amount - 1.25% Start Rate - 5.5% Fully Indexed Rate

Payment #1 (Minimum Payment) - $833.13
Payment #2 (Interest Only Payment) - $1,145.83

Example 2

$450,000 Loan Amount - 1.25% Start Rate - 5.5% Fully Indexed Rate

Payment #1 (Minimum Payment) - $1,499.63

As you can see, there can be quite a difference between payment options!

If you want to run your own scenarios, We've built a simple, Excel based, Pay Option Calculator that you can download for free. Check out the resource box below for information on how to download this great little tool.

Hopefully, this gave you some insight into what an Option ARM loan is and how it works.

If you are interested in learning more about this program, and if you are eligible for it, your next step should be contacting a mortgage professional.

IMPORTANT NOTICE

Beware companies or individuals that make you put money down or order an appraisal BEFORE they agree to discuss your situation with you. Also, be wary of those who won't talk to you until they pull your credit report. While a credit report will be necessary if you decide to go forward, you have the right to talk to someone about your options before they look at your credit. These are frequently just sales tactics to make you feel like you are obligated to go forward with that particular broker or lender.