Payment Option ARM: What It is, How It Works

What Is a Payment-option ARM?

A payment-option ARM is a monthly adjusting adjustable-rate mortgage (ARM) that allows the borrower to choose between several monthly payment options. The payment options can include interest only or principal and interest.

However, some options include making a minimum payment that doesn't cover the monthly interest, which can increase the borrowed loan amount over time. Although payment-option ARMs offer flexibility, they carry risks if the loan balance increases and you can't repay the loan.

Understanding Payment-option ARM

Typically, a fixed-rate mortgage payment involves a portion of your monthly payment going to pay the principal and interest. The principal is the original amount that you borrowed, while the interest is the monthly amount charged by the mortgage lender derived from the loan's interest rate.

When repaying your mortgage loan, if you don't repay the principal, you're not paying off any of the debt that you originally borrowed. If you don't repay all of the monthly interest charged, the unpaid interest gets added to your loan balance, increasing how much you owe—called negative amortization. For the sake of discussion, property taxes and homeowners' insurance have been excluded.

Adjustable-rate mortgages (ARMs)

Adjustable-rate mortgages (ARMs) offer flexible payment options for borrowers, offering a fixed-rate initial period followed by a reset or adjustment to the rate based on market interest rates. For example, a 5/1 ARM would have a fixed rate for the first five years and reset once per year following the initial period. Typically, there is an annual cap that limits how much the rate can reset higher during any one period to protect the borrower if interest rates rise dramatically.

Payment-option ARM

A payment-option ARM offers borrowers a few monthly payment options, including the following:

• A fully amortized payment, meaning the payment includes a portion that goes to principal and interest with terms of 15, 30, or 40 years
• An interest-only payment, meaning it doesn't pay down the principal or reduce your mortgage loan
• A minimum or limited payment that doesn't cover all of the interest or a payment of any amount greater than the minimum

The minimum payment option is calculated based on an initial temporary start interest rate. While this temporary start interest rate is in effect, this is the only payment option available. It is a fully amortizing payment. After the temporary start interest rate expires, the minimum payment amount remains a monthly payment option. However, whenever a payment is made that is less than the scheduled interest-only payment, deferred interest is created.

Payment Increases with Payment-option ARMs

Payment option ARMs can have a great deal of payment-shock risk. The monthly payments might increase for several reasons, including an unscheduled recast when a negative amortization limit is reached. The fully indexed interest rate is important in this calculation. The rate of negative amortization is a function of the interest-only payment (based on the fully indexed interest rate) and the minimum payment.

If the fully indexed interest increases substantially, the rate of negative amortization increases when only the minimum payment is made. As a result, the negative amortization limit will likely be reached and the mortgage will recast, meaning the payment schedule gets recalculated.

Caveats of Payment-option ARMs

To avoid substantially increasing the amount of debt that is owed on a mortgage, the borrower must carefully choose the repayment structure with a payment option ARM. While popular in the lead-up to the 2008 financial crisis, payment option ARMs later drew criticism. The nature of this type of mortgage allowed borrowers to make smaller payments, which they believed they could accommodate, but the overall debt on the mortgage continued to grow rather than reducing the balance.

After the mortgage crisis struck, it came to light that some lenders offered payment options ARMs to borrowers who otherwise did not qualify to purchase the homes. Although these mortgages could cover the sale prices of the homes, the way the debt could escalate if the borrower did not pay off the interest and reduce the principal balance meant that borrowers who could not afford the debt would inevitably default.

There are benefits to payment-option ARMs, particularly for real estate speculators looking to make short-term investments in property, especially if they intend to refurbish and put the property back on the market in short order.

The Bottom Line

A payment-option ARM is a type of adjustable-rate mortgage (ARM) that allows the borrower to choose between a few monthly payment options. The options can include a monthly payment that covers principal and interest, which reduces the amount owed. Other options include an interest only and a minimum payment, which doesn't cover the total monthly interest owed. Neither the interest only or minimum payment options reduce the mortgage loan amount and paying less than the interest can increase the loan balance.