The adjustable rate mortgage (ARM) has become a staple in today's housing market. The concept is that your mortgage payment starts out at a certain (low) interest rate and is adjusted periodically, usually on a yearly basis. The rate adjusts in conformance with some money market indicator, such as the cost of one year Treasury notes. If the cost of T-bills has gone up a certain percentage, so goes your interest rate for the next year.
That's a relatively simple formula. But as housing costs have skyrocketed, the lending institutions have cooked up increasingly complicated forms of the ARM that have allowed home buyers to obtain mortgages for homes they would not be able to touch with a thirty year fixed rate mortgage, or even a normal ARM. One such beast is the option ARM.
An option ARM (aka Optional Payment Mortgage) is an adjustable-rate mortgage that allows the borrower to choose from four types of payment each month. The borrower can make a standard mortgage payment (principal, interest, taxes, insurance or PITI) that will pay off the loan off in 15 years or in 30 years. Or, the borrower can choose to pay only the interest charged in the previous month. Finally, the borrower can make a minimum payment that doesn't even cover the interest – a convenient option when times or tight, but one which increases the total amount owed on the mortgage.
Most option ARMs have ridiculous introductory interest rates that are simply teasers, sometimes below 2 percent. Those rates usually last a month or two, rarely more. At that point, they begin to rise and continue to do so with clockwork regularity. The truly hidden risk in an option ARM is that although the interest rate changes every month, the required monthly payment changes only once a year.
If the introductory interest rate starts at two percent, it is going to double, then triple, then probably quadruple and maybe continue beyond that. While the interest rate hikes are going on in the background, the minimum payment rises at a maximum rate of 7.5 percent a year. The result is often what is known as “negative amortization.” What is occurring is that as the home owner is making payments on the option ARM, the balance owed on the loan is steadily increasing.
People who select option ARMs as their mortgage of choice had better be fully informed and be adept at math. It is not uncommon for mortgage debt to rise at the rate of several hundred dollars per month while the home owner is making those easy payments; however this process can only proceed to a point. Most lenders will not allow debt on an option ARM get beyond 110 percent of the loan's initial amount. When you hit the principal cap, you will be required to begin making payments on principal as well as interest.
What the new payment schedule will be dictated by the terms of the mortgage and your current interest rate. If you reach the principal cap, however, the jump in your monthly obligation is going to be enormous. The option ARM has financial factors built into it that shift constantly and many home owners are simply not geared to keep up with them.