Adjustable rate mortgages (ARMs) that offer borrowers four payment options are commonly referred to as option ARMs. Option ARMs are also known as negative amortization loans because any unpaid interest on the loan will be added to the outstanding principal balance. Option ARMs have very low initial interest rates, which means that borrowers will have very low minimum payments for a specified period of time. Typically, this low initial interest rate will remain unchanged during the first year of the loan. Borrowers should be aware that if they select the minimum payment option available to them in the early years of the loan, they will likely experience a sudden increase in monthly payments in later years. For this reasons, option ARMs may not be suitable in every situation.
Option ARMs Payment Options
There are four options available to borrowers that choose to finance their home with an option ARM. These four options are: minimum payment, interest only payment, fully amortizing 15 year payment, and fully amortizing 30 year payment.
Option ARM Minimum Payment
For the first 12 months of the loan, a borrower may choose to make minimum payments based on an initial interest rate. Borrowers are encouraged to only make minimum payments during the first 12 months of the loan. At the end of the initial interest rate period, minimum payments may not cover all of the interest due. Any unpaid interest will be added to the loan's remaining principal balance.
Option ARM Interest Only Payment
To avoid deferred interest and negative amortization, borrowers may opt to make interest only payments on their option ARM. Borrowers should be aware that interest only payments could change each month based on changes in the loan's interest rate. Furthermore, borrowers may not have the option of an interest only payment if the minimum payment is greater than the interest only payment.
Option ARM Fully Amortizing 15 Year Payment
With the fully amortizing option, borrower will pay both principal and interest each month. For borrowers that can afford a higher monthly payment, a fully amortizing 15 year payment may be ideal. This payment option helps borrowers to pay off their loan balance more quickly – actually two times faster than a fully amortizing 30 year payment. Not only does the 15 year payment plan allow borrowers to pay off their loan more quickly, it also saves them half of the total interest costs of a 30 year payment plan as well.
Option ARM Fully Amortizing 30 Year Payment
Borrowers that cannot afford the fully amortizing 15 year payment but would like to keep their loan on schedule may opt for the fully amortizing 30 year payment instead. The monthly payment for this loan payment option will be calculated each month and will be based on several factors including the prior month's fully indexed rate, the remaining balance on the loan, and the remaining loan term.
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