What is an Option ARM

Have you hear of an option ARM? You may know about it, but it is something many people are not completely familiar with. So, here is a brief background on what an option ARM is. You may find that it is something that interests you, or maybe not. But either way, learning about it is very important.

Option ARM Basics

The rate on an option ARM will be adjusted monthly. The minimum payment will be adjustable every year however. When that happens, that rate will become fixed for the entire year until it is adjusted again. There are three indexes used to base the option ARM rate on. They are: the COFI (11th District Cost of Funds Index), the MTA (12-month Moving Treasury Average), and the 1-month LIBOR (One-Month London Interbank Offered Rate). These rates are tracked weekly.

Minimum Payments on an Option ARM

Now we have already noted how the minimum payment is only adjusted annually and will remain fixed at that rate for an entire year. But if that rate rises later, the current minimum payment will not cover the interest charged. So it is possible that you can find you owe more on the mortgage at the end of the month then you did at the beginning of that month. This can even be possible after making that minimum payment. This is what is called negative amortization.

There is also a term call “recast.” Usually an option ARM will set a limit at 7.5%. No minimum payment can be increased by more then that, but that limit is lifted after five years. That is when the loan is “recast”. Unfortunately right after this point the minimum payment can jump up drastically. The payment cap removal is what causes that jump. In some cases, payments have been known to actually double in size, maybe even larger. That is a major increase in payment, and some people do not even see it coming.

What Situation is Best For an Option ARM

Because of the payment jumps and the rising rates that could occur, an option ARM is obviously not a great choice for everyone. The perfect situation for an option ARM is for someone who can actively and successfully manage their financial situation, has the finances to cope with the jump in payments, or someone who is going to move or refinance within a short period of time. You are more likely to find yourself in trouble if you are looking at an option ARM because you do not want a long term fixed rate mortgage. That may be trouble, because you may also not be able to afford the jump in payments. Like always, just do your homework. Find what works out best for you. Because it you manage the situation according to what you know you can afford to do, you will be fine. Do not jump ahead of yourself at all.

Additional Resources:

www.optionarmfacts.com - Option ARM Facts

www.washingtonpost.com/wp-dyn/content/article/2007/04/29/AR2007042900035.html - Negative Amortization

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[Source: Mortgage Blog]