DEFINITION of the Variable Rate Mortgage Option (Option ARM)
A variable rate mortgage (ARM) is a type of mortgage where the mortgagor (borrower) has several options as to the type of payment to be made to the mortgagee (lender). In addition to having the choice of making interest and principal payments equivalent to those made in conventional mortgages, option ARMs also have alternative payment options where the mortgagor can make much lower payments by making interest only payments or minimum payments.
DEVELOPMENT Variable rate mortgage (ARM option)
Since many option ARMS offer a low teaser rate, many mortgage debtors unknowingly refinance their current mortgage in the hope of making lower payments. Unfortunately, once these short-term interest rates have expired, the interest rates return to those similar to conventional mortgages.
In addition, for the unlucky mortgage debtors who choose to make minimum payments, they will find that the principal owed on their mortgage has actually increased. The value of the minimum payments did not fully cover the interest on the mortgage. Unhedged interest would then be added to the mortgage capital.
Payment methods for optional MRAs
In a common scenario, the lender can let the borrower with an ARM option decide each month what type of payment they want to make. These choices may include a minimum payment, an interest-only payment, a fully amortized payment on a 15-year mortgage, or a amortized payment on a 30-year mortgage.
While the choices available with an ARM option allow for greater flexibility in payments, the borrower could easily be dealing with longer term debt than at the outset. As with other variable rate mortgages, interest rates may change dramatically and quickly depending on the market.
An ARM option may appeal to households where income can fluctuate, as with professions that operate on commission, under contract or as self-employed. If they don’t see as much work coming, choose to pay the minimum on a mortgage. While this may allow them to keep more money on hand, the minimum amount may increase each year. In addition, the minimum payment can be recast at five or 10 year intervals to be fully amortized.
These cautions can be ignored by borrowers, which can leave them unprepared for the potential increase in costs and increase in the principal balance. If the borrower continues to make only the minimum payment and the outstanding balance increases to exceed the original value of the mortgage, for example 110% or more, the mortgage could automatically reset. ARM options have been cited as contributing to the housing crisis that developed after borrowers sought such financing for houses they could not afford. In these cases, borrowers paid only the minimum amount due each month with an ARM option, and then ended up unable to pay for their home or the mortgage increased as the sale value of the home dropped.