Option Adjustable-Rate Mortgage (Option ARM)

An Option Adjustable-Rate Mortgage (Option ARM), also called a flexible-payment ARM, is a mortgage that lets the borrower choose among several monthly payment options. Typical choices include a 30-year fully amortizing payment, a 15-year fully amortizing payment, an interest-only payment, or a minimum payment that may not cover all accrued interest. The unpaid interest under a minimum payment is added to the loan principal (negative amortization).

Key points

• Offers multiple monthly payment options each month (30‑yr amortizing, 15‑yr amortizing, interest‑only, minimum payment).
• Minimum payments can produce negative amortization — the loan balance can increase.
• Many Option ARMs began with low teaser rates that later reset, causing payment shock.
• Regulations put in place after the 2007–2008 housing crisis greatly reduced the availability of Option ARMs.

How Option ARMs work

Option ARMs typically have:
* A variable interest rate tied to an index plus a margin (for example, an index like LIBOR or another published benchmark).
* An introductory (teaser) rate that may be much lower for a short period.
* Monthly flexibility: borrowers choose their preferred payment type month to month.
* Periodic recasts or resets that convert the loan to a fully amortizing payment if negative amortization or other trigger thresholds are reached.

If a borrower repeatedly selects the minimum payment that does not cover interest, the unpaid interest is added to the principal. Over time this increases the loan balance and can push the loan balance past the home’s value.

Example

Assume a loan balance of $200,000 with an annual interest expense of $12,000 (about $1,000/month). If the borrower’s minimum payment is $700, $300 of interest is unpaid and is added to the principal. The new balance rises to $200,300, and future interest charges are calculated on the larger balance, accelerating growth.

Risks and pitfalls

• Negative amortization: making minimum payments can increase the principal balance.
• Payment shock: when teaser rates expire or interest rates rise, monthly payments can jump significantly.
• Recasts/resets: some loans automatically recalculate payments to fully amortize over a shorter period if balances grow beyond set thresholds, causing large payment increases.
• Housing market exposure: if home values fall while balances grow, borrowers can become underwater and face difficulty selling or refinancing.
• Complexity: payment options and triggers can be confusing; borrowers may underestimate long-term costs.

Option ARMs were widely used before the subprime mortgage crisis, contributing in some cases to borrower defaults when payments rose and home values dropped. Subsequent regulatory changes (including Qualified Mortgage standards) have largely curtailed the use of Option ARMs.

Who might consider an Option ARM

Option ARMs may appeal to borrowers with highly variable income (commission-based, seasonal, or freelance work) who need short-term payment flexibility and who are confident they can make larger payments later or refinance before rates reset. However, because of the significant risks, they are generally not recommended for borrowers who need predictable long-term payments.

How to avoid problems

• Prefer fully amortizing payment options when possible.
• Avoid minimum payments that do not cover interest.
• Understand index, margin, caps, recast triggers, and how often rates reset.
• Plan for the end of any introductory period and for possible rate increases.
• Consider fixed-rate mortgages or safer ARM structures if you need predictability.
• Use mortgage calculators and consult a trusted mortgage professional to model worst‑case scenarios.

Conclusion

Option ARMs provide monthly payment flexibility but carry substantial risk, including growing principal and sudden payment increases. They require disciplined planning and careful monitoring; for most borrowers, more straightforward mortgage options with predictable payments are safer.