An option adjustable-rate mortgage (ARM) is a type of home loan with an adjustable interest rate and payment structure. Option ARMs allow borrowers to choose between a variety of payment options, including a minimum payment option that is less than the actual interest due on the loan. These loans are attractive to borrowers who are looking for lower payments with the ability to partially defer principal on the loan, but have come with high risks due to the adjustable nature of the loan.
Exploring the Option ARM
The option ARM is beneficial when interest rates drop because it allows borrowers the flexibility to take advantage of lower monthly payments. It is less beneficial when interest rates rise since borrowers end up paying more than they originally expected. Additionally, when interest rates rise, the amount of deferred principal can increase instead of decrease, resulting in negative amortization.
The option ARM also comes with a prepayment penalty which means borrowers may need to pay a fee if they choose to pay off the loan balance early. This makes it difficult to refinance or pay off the loan within a short period of time. On the plus side, this type of loan can have a fixed-rate option which comes with a fixed interest rate and no prepayment penalty.
Balancing the Pros and Cons of an Option ARM
It’s important to assess the pros and cons of an option ARM so you can make an informed decision and determine if it could be a beneficial option. While the minimum payment option of an option ARM provides an appealing benefit, there are also risks associated with this loan. These risks include the possibility of negative amortization and a prepayment penalty when applicable. Keep all of these details in mind when evaluating your financing options.