What is a Pay Option ARM loan?

Is this the right program for you?

The Option ARM or Pay Option ARM became extremely popular a few years ago when rates were at an all time low. At the time there were only a few lenders that offered these programs. Eventually every lender began offering there own version of the Pay Option ARM. Most likely you have been offered this product and probably know someone that has it.

In order to understand it you should know what the features are of this product. Furthermore we will go through the advantages and disadvantages associated with the Pay Option ARM loan.

Main features of the Option ARM.

Lenders typically offer a low start rate.

Usually ranging from 1.00% to 1.50%. This rate is how the lender will calculate your minimum payment. Your minimum payment is the least amount the lender will accept from you per month to keep your loan in good standing.

Four payment options

Minimum payment, interest only payment, 30 year fixed payment and 15 year fixed payment. This is the big selling point, where you are able to choose your monthly payment each month. You can pay the minimum or any other payment.

In most cases the minimum payment is fixed for the first year.

After the initial year it will increase by 7.5% of the payment each year moving forward.

Fully indexed rate

Which is the Margin plus the Index, is used to calculate your other payments (30, 15, and interest only payments). This is the adjustable part of the loan, each month the interest rate is calculated based off of that formula. The Margin is selected during the application process and is fixed for the life of the loan. The Index is the part that will change each month and therefore cause your rate and payments to increase or decrease.

Now that you have a basic understanding of the main features of the loan let's talk about some of the advantages you could see from this loan.

Cash flow flexibility, you are able to pay as little as the minimum or as much as the 15 year amortized payment. If you choose the minimum you could free up some of your budget for other items that month.
Freedom of choice, you are able to choose what payment to send. You have 4 different mortgage options in 1 loan. You can pay either one that you choose, not just the 1 payment with most loans.

As you can see from above this loan was very easy to promote and advertise. It has extremely low rates and payments to show potential borrowers.

However there are some disadvantages that you should know about.

Adjustable rates that change each month.

The indices mainly associated with these programs have increased each month for the past 2 years. So if you aren't comfortable with a changing rate effected by the market this might not be the best product.

Deferred interest (or negative amortization) is a huge drawback.

The difference between the interest only payment and the minimum payment each month is the deferred interest. Therefore if you were to pay the minimum payment that deferred interest is added back to the loan balance. If you paid only the minimum payment on this loan for the first year you would owe more than the orginial principal balance. Most mortgage consultants will advise clients to pay at least the interest only paymnet each month in order to avoid the deferred interest.

Prepayment Penalties

Most of these loans will have a prepayment associated with them. Make sure you know the terms, how long it will last and how much it would cost.

As you can see these programs are very involved and require a great deal of thought and research prior to obtaining one. Make sure you ask all the right questions up front you do not want to enter into one of these loans and then try to refinance out of it.

What is a Pay Option ARM loan?

Main features of the Option ARM.

However there are some disadvantages that you should know about.

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