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

The "payment shock" on an option ARM can be a doozy.

The "payment shock" on an option ARM can be a doozy.

You don't have to be a Wall Street financier to gamble on the future of interest rates. An adjustable-rate mortgage, or ARM, lets you do it from the comfort of your home. In fact, your home itself represents your wager. But while taking out a conventional ARM might be like playing a slot machine — sometimes you win, sometimes you lose — jumping into an "option" ARM can be like going all in on a poker hand with only a pair of 2s.

ARM Basics

A traditional home loan has a fixed interest rate, meaning the rate never changes, so your monthly payment is predictable. With an adjustable-rate mortgage, the rate (and the amount of your payment) can rise or fall depending on the overall direction of interest rates in the economy. To entice borrowers, ARMs usually start with a low introductory interest rate, called a "teaser," that's good for a set period of time before rising to a market-based rate. The interest rate then adjusts at regular intervals, often once a year, and your payment adjusts with it. The loan typically limits how much the rate can rise or fall in any particular adjustment, as well as over the lifetime of the loan.

Conventional ARM

The definition you just read pretty much sums up the conventional adjustable-rate mortgage. Most conventional ARMs have a term of 15 or 30 years. Whenever the rate adjusts, your lender recalculates your payment so that you remain on track to have the loan paid off at the end of those 15 or 30 years. Lenders refer to such payments as "fully amortizing." Remember that term, because it becomes especially important when discussing option ARMs.

Option ARM

What makes the option ARM different is — as you've probably deduced — the "option." Each month, the lender gives you a choice of payments: one that fully amortizes over 30 years; one that fully amortizes over 15 years; an interest-only payment; and a "minimum payment." With the fully amortizing options, each payment includes both interest and principal, so you're paying down what you owe and staying on track to pay the whole thing off. With the interest-only option, you pay only the interest that accrued over the past month. You don't pay down the loan principal, so you aren't getting any closer to paying off the loan, but you aren't falling behind, either. The minimum payment, however, is an interest-only payment based on the initial teaser rate rather than the current (higher) interest rate. What that means is that not only are you not paying down the principal, you aren't even paying off all the interest you're accruing. The unpaid interest then gets added on to the balance of the loan itself. The technical term for this is "negative amortization." The not-so-technical term is "financial quicksand."

Payment Shock

An option ARM might make sense for financially disciplined people who need flexibility — those with irregular incomes, such as commissioned salespeople or contractors who work only seasonally. They could make the minimum or interest-only payments when money is tight, then pay more when they have money coming in. However, many people have taken out option ARMs simply because they were seduced by that low minimum payment. The problem is, the minimum doesn't stay that low forever. After a year or so, the minimum will rise. The typical option ARM caps the annual increase at 7.5 percent. But there are two huge exceptions. The first is that every five or 10 years, depending on the loan, the minimum payment gets reset or "recast" to a fully amortizing amount. The second exception is that when negative amortization pushes the loan balance to a certain pre-specified amount — say 115 percent of the original loan — the minimum payment also recasts to a fully amortizing amount. The change can be — and usually is — enormous. There's a name for this: payment shock.

No Longer an Option?

According to Jack Guttentag, a retired finance professor who runs the website The Mortgage Professor, option ARM payment shock proved to be more than many homeowners could afford. That led to such high default rates on option ARMs that these loans essentially disappeared from the market around 2008. As of 2012, they hadn't returned, but no regulations prevent lenders from offering them again if they so choose.

About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.

Photo Credits

  • Photodisc/Photodisc/Getty Images