What Is the Difference Between an Option ARM & a Conventional ARM?

Option ARMs offer flexible mortgage payment options.

An adjustable rate mortgage (ARM) is a mortgage in which the interest rate changes at specific intervals based on a specified index. The difference between an option ARM and a conventional ARM is that the option ARM provides several options as to how much the borrower can pay each month.

Conventional Payments

The monthly payments for a conventional ARM are interest and principle amortized over the life of the loan. The borrower makes the same fixed payment each month while the loan is at a set interest rate. Payments change only when the interest rate changes.

Option ARM Payments

With an option ARM, each month the borrower typically has four payment options:

(1) an interest/principle payment based on a 15-year payoff schedule;

(2) an interest/principle payment based on a 30-year payoff schedule;

(3) an interest-only payment based on a 30-year payoff schedule; or

(4) a negative amortization option in which the payment is less than the interest.

Benefits of Option ARMs

The primary benefit of an option ARM is for people who have variable monthly income. They can make smaller payments in months of less income and larger payments in months of more income. This benefit often lets a person qualify to buy a more expensive house.

Risks of Option ARMs

Option ARMs have two major risks:

(1) Borrowers buy a house that is too expensive for their financial situation and cannot keep up the payments; and

(2) the minimum required monthly payment could more than double from month to month, especially if the borrower is consistently making only the minimum required payments.

References

• Investopedia: Adjustable-Rate Mortgage Indexes: Know Your Benchmark
• Bankrate: Option ARMs have benefits and also risks