In the months leading up to the housing crisis a decade ago, option ARM mortgages were pretty popular. That’s because they allowed homeowners to take advantage of flexible payment terms, allowing them to better manage their budgets and cash flow. Back then, mortgages were easier to get approved for, even if borrowers weren’t financially capable of handling them.
Basically, an option ARM mortgage is a type of home loan that gives borrowers the freedom to choose how much a certain monthly payment will be. As such, they are quite attractive loan options that many borrowers have opted for.
Having said that, they can also be somewhat dangerous if the proper precautions aren’t taken.
What is an Option ARM Mortgage?
An option ARM loan is essentially a form of an adjustable-rate mortgage (hence the acronym “ARM”) and lets borrowers choose among several different payment options. For instance, these types of home loans might let borrowers make the following types of payments:
Low minimum payment – This amount barely covers the interest. Any interest that’s not paid is added to the principal mortgage balance and therefore increases the amount of debt owed. The monthly payment is set for 12 months at the introductory interest rate, after which the payment changes every year.
If only the minimum amount is paid once the initial interest rate period ends, it might not cover all of the interest charged on the mortgage for the month prior. Any unpaid interest is then included in the principal balance.
Interest-only payment – This amount does not pay down the principal. Instead, whatever amount is paid goes towards the interest portion only.
Fully amortizing payment – This amount goes towards both interest and principal and is the only way to decrease the debt amount owed. It’s the only option that keeps the mortgage on track.
The Dangers of Option ARM Mortgages
The flexibility in payment options that these types of home loans offer can be very alluring to borrowers. But option ARM mortgages can be risky and can often lead to financial trouble down the road.
Also referred to as “cash-flow loans” and “pick-a-payment loans,” option ARM mortgages are often offered at low-interest rates in order to entice borrowers. However, many borrowers may not realize that these introductory rates are not permanent and expire at a date in the near future. At that time, the rate will increase, leaving borrowers to make higher payments on their mortgages.
In addition, no equity will be accumulated in your home unless you make amortizing payments. By only making smaller payments, you will inevitably owe more on your home at the end of each month, mounting your debt. In actuality, you could find yourself paying interest on the interest.
Furthermore, you won’t be able to take advantage of all those small payment options for the long haul, since your lender will eventually want you to start paying off your home loan.
Every few years (depending on the terms as set by your lender), your mortgage will be recast, especially if you owe too much on your home compared to what you started out with. In fact, it’s not uncommon for borrowers to owe more much more on their home than the original loan amount at some point down the line.
When the lender decides to put your mortgage back on track in order for it to be fully amortized, you’ll likely see a significant increase in monthly mortgage payments. If these payments suddenly overshadow your budget, you could find yourself in financial trouble.
What many borrowers might not fully be aware of is that making minimum payments every month is only postponing the payment of interest, not eliminating it.
Borrowers can easily get caught up in the idea of not having to pay any interest for a while, putting more money in their pockets that would have otherwise been spent on interest payments. But all that accrued interest will creep up eventually, forcing borrowers to make much larger payments without having the benefit of having built up any equity in the home.
The Bottom Line
Option ARM loans should only be considered if you’ve done your due diligence and worked out a solid budget that can support this arrangement. It’s also wise not to count on making minimum payments or interest-only payments over the long term, and only take advantage of this flexibility on occasion as the need arises.
Consistently making these low payments will only grow the amount owed and make it much more expensive to pay down your mortgage. Be sure to speak with a mortgage specialist before choosing an option ARM mortgage.