What Is an Option Adjustable-Rate Mortgage?

An option adjustable-rate mortgage is a type of adjustable-rate mortgage (ARM) that offers borrowers several payment options. The payment options might include payments applied only toward the interest and principal, the interest payments only, or for paying a minimum amount due. 

While option adjustable-rate mortgages can offer payment flexibility for homebuyers, there are some important drawbacks to note.

Definition and Examples of Option Adjustable-Rate Mortgages

An option adjustable-rate mortgage is an adjustable-rate mortgage that features several payment options. Option ARM loans are not as popular as they once were.

• Alternate name: Option payment ARM, payment-option ARM, pay option ARM

It helps to know about the basics of adjustable-rate mortgages to understand option ARMs. An adjustable-rate mortgage allows homebuyers to pay one low, fixed rate for a set time period. Once that initial rate period ends, the mortgage rate can adjust to align with its benchmark rate. For example, a 5/1 ARM has a fixed rate for the first five years. After that, the rate adjusts one time per year until the loan is paid off.

With an option ARM, the lender can offer you several possibilities for making payments toward the principal and the interest on the loan. The payment option you choose can directly affect how quickly you're able to reduce the interest and principal on the loan.

For example, say you have an option ARM and your lender allows you to make interest-only payments. As you make payments each month, they go toward the interest on the loan but don't affect the principal.

How an Option Adjustable-Rate Mortgage Works

If you do find a lender that offers option ARMs, you may be able to take advantage of a flexible payment structure that allows you to decide how you want to repay your loan. You may find one of the following options for repayment:

• Interest and principal: This option is akin to a traditional mortgage payment, with some of the payment going toward interest and some toward the loan principal. Payments may be amortized on a 15-, 30-, or 40-year payment schedule.
• Interest-only: Payment-option ARMs also allow for interest-only payments. In this case, payments would be applied to the interest on the loan, not the principal, for a specified period of time. After that period, your monthly payment would increase—even if interest rates stay the same—because you have to start paying back the principal as well as the interest each month.
• Minimum or limited payment: This third payment option allows you to pay a minimum amount that may be less than the interest due on the loan. 

Typically, payment-option ARMs have a low interest rate for the first few months. So you might pay 1% or 2% on the loan initially, then see that rate adjust. The monthly payments you make during the first year are based on the initial loan rate. So if you choose the minimum or limited payment option that doesn't cover the interest, the unpaid interest will get added to the loan balance, increasing the loan balance and the interest you will ultimately pay.

This is called negative amortization. In simple terms, it means that even as you make payments toward the loan, the balance won't go down if those payments don't cover the interest. Negative amortization can be problematic, as it could lead you to owe more on the mortgage than the home is actually worth.

Option ARMs can cap how much your monthly payment may increase year over year. Your loan payments are typically recalculated every five years, based on how much time is left on the original loan term. The payment cap does not apply to these adjustments, however.

Criticism of Option Payment ARMs

Option ARMs are designed to appeal to homebuyers who desire payment flexibility. In the mid-2000s, more mortgage lenders began marketing option ARM home loans as a low-rate option for borrowers. By 2006, payment-option ARMs accounted for 9% of the total mortgage market.

The problem with option ARMs lies in the way they're structured. Making interest-only payments, for instance, means that nothing is applied toward your loan principal, so your loan balance doesn't go down. As your interest rate adjusts, your monthly payment might increase but you're not making headway on what you owe. 

Meanwhile, the minimum payment option can add to the balance if you're paying less than the interest each month. Think of it as paying the minimum payment due on a credit card. You may consistently pay $50 a month, but if the interest charges are $100 a month, you're basically getting nowhere fast. 

Option-payment ARMs, along with other subprime mortgages, such as no doc and liar's loans, came under close scrutiny following the 2008 financial crisis. The result was that lenders began pulling back on offering them. Wachovia Bank, for example, opted to discontinue option ARMs in 2008. That did not, however, prevent the bank from being targeted for a class-action lawsuit surrounding payment-option ARMs, which resulted in a $627 million settlement.

Today, option ARMS have all but disappeared from the mortgage market. Lenders can still offer interest-only mortgage loans, however, in which payments are made toward the interest-only for a set time period. Remember that paying interest-only does not reduce the balance on your loan.

If you have an interest-only loan or ARM, consider whether refinancing to a low fixed-rate loan could save you money.