Option Adjustable-Rate Mortgage (Option ARM)

An option adjustable-rate mortgage (Option ARM) is a type of mortgage that gives the borrower the option to make either a fixed or adjustable interest rate payment each month. The interest rate on an Option ARM is usually fixed for the first few years of the loan, after which it adjusts based on an index plus a margin. The margin is a fixed amount that is added to the index to determine the interest rate.

There are two main types of Option ARMs:

• Negative amortization Option ARMs: With a negative amortization Option ARM, the monthly payments are not enough to cover the interest that accrues on the loan. As a result, the loan balance increases over time.
• Positive amortization Option ARMs: With a positive amortization Option ARM, the monthly payments are enough to cover the interest that accrues on the loan and also make a small principal payment. As a result, the loan balance decreases over time.

Option ARMs can be risky for borrowers because they can allow borrowers to take on more debt than they can afford. If borrowers do not make enough payments to cover the interest that accrues on the loan, their loan balance can increase significantly. This can make it difficult for borrowers to sell their homes or refinance their loans.

Option ARMs are also often marketed to borrowers with poor credit histories. This is because Option ARMs typically have lower interest rates than other types of mortgages for borrowers with poor credit. However, the lower interest rates on Option ARMs can be offset by the risk of negative amortization.

Option ARMs are not as popular as they once were. In 2008, the U.S. government passed the Mortgage Reform and Consumer Protection Act (Mortgage Reform Act), which imposed new restrictions on Option ARMs. These restrictions made it more difficult for lenders to offer Option ARMs, and as a result, the number of Option ARMs issued has declined significantly.

Despite the new restrictions, Option ARMs can still be a risky choice for borrowers. If you are considering an Option ARM, be sure to understand the risks involved before you sign on the dotted line.