With an option ARM mortgage, borrowers get to choose how much they want to pay off each month. Option ARM mortgages are becoming increasingly popular due to the instable economy. With people worrying that they may not always have a high, steady paycheck coming in, the flexibility of an option ARM mortgage can help reduce monthly expenses. An option ARM mortgage also allows buyers to qualify for a loan which they wouldn’t be able to under a full-interest mortgage.
Option ARM mortgages are a good choice for people who have fluctuating incomes. But they should also be very disciplined about making payments because the loan will periodically be reformatted so that it meets the amortized rate. This is done to help the borrower stay on track of paying off the loan. If you only make the minimum payments each month, then the amount of your payments is going to jump incredibly when the loan is reformatted. If this happens, borrowers can experience a payment shock in which puts them at risk of defaulting.
Another major risk of option ARM mortgages is negative amortization. This occurs in situations where the borrower only pays off an amount which is less than the accrued interest on the loan. Because the unpaid interest also accumulates interest, the borrower can end up owing much more than what was borrowed. Negative amortization is very dangerous, particularly when the real estate market is down. Even if the borrower were to sell off the property for the original buying price, the borrower would still be in debt.
Borrowers can avoid negative amortization completely if the appreciation is at least 3%. A borrower can calculate the difference between the minimum payment and full-interest payment amounts. Then, this amount can be put into a tax-free IRA or 401K plan. The interest earned from these savings plans can outpace the negative amortization.
When an Option ARM is a Good Idea
If you are an irresponsible borrower who will be tempted to make only the minimum payments, then you can forget about an option ARM. The risk of negative amortization is just too high. Also, be aware that many lenders are reluctant to give a second mortgage if you still have an option ARM. So this type of loan may not be ideal if you are planning to get a second mortgage in the near future.
Option ARMs are a good idea for people with fluctuating incomes, who are responsible about making payments, and may want to purchase a larger home than they would normally qualify for. If you are only planning on being in the home for a short time (such as buying and then reselling), then an option ARM mortgage can also be very useful because it minimizes costs but does not have the risk of turning into large negative amortization debt.