How Does an Option ARM Loan Work?

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    Payment Options

    • This type of loan is referred to as an option adjustable rate mortgage, because it gives the borrower options on what he wants to pay each month. Most option ARM loans give the borrower four options each month. One option allows the borrower to make a full mortgage payment. Another option allows a person with a 30-year mortgage to make a larger payment that would be similar to a 15-year mortgage payment. The borrower can also choose to make an interest-only payment or a minimum payment that is less than the interest-only payment.

    Adjustments

    • One of the features of this type of loan is the adjusting interest rate. The interest rate adjusts on a monthly basis with the option ARM loan. The payment choices also change on an annual basis. This means that if the interest rate increases substantially over the course of year, you may not be paying the full amount of interest that is accruing, even if you make the full mortgage payment. The interest you do not pay is added to the total balance of the mortgage, which is referred to as negative amortization.

    Advantages of Option ARM

    • One of the primary advantages of using this type of loan is that it provides flexibility and a low payment during the first year. When you get an option ARM mortgage, you usually can make a much lower monthly payment than you could with a fixed-rate loan. This could provide you with the opportunity to buy a house you ordinarily would not be able to afford. If your income is received on an irregular basis, having the ability to choose your payment can be an attractive feature.

    Risks

    • The option ARM loan is one of the most complex and dangerous loans in the mortgage industry, according to a 2006 report by Businessweek, and has contributed to many foreclosures. With this kind of loan, the payment can rise significantly after the first year. With the negative amortization, the balance of your loan could be increasing instead of decreasing over time. This means that when your payment is recalculated, it will be based on the new, higher balance.

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