Option ARM Terms and Structuring
Option adjustable-rate mortgages (Option ARMs) are complex mortgage products that allow for payment flexibility. Familiarize yourself with basic mortgage contract terms, prior to evaluating concepts related to the structure of option ARMs. Because of their unique structure, option ARMs may be best suited for experienced real estate buyers. Option ARMs introduce risks of negative amortization, where your loan balance may actually increases over time.
Real Estate Collateral
Mortgage loans are secured by real property as collateral. The collateral provisions mean that lenders may foreclose on, or seize, your home to make good on any missed payments and unpaid balances. Mortgage amortization relates to the series of payments that take your principal down to zero, with interest. Mortgage principal describes your loan balance, while interest charges compensate banks for making loans.
Mortgage Interest Rates
Mortgages charge interest at either fixed, or adjustable rates (ARMs). Fixed-rate mortgages carry level interest rates throughout maturity. ARMs, however, feature interest rates that fluctuate monthly according to prevailing rates. ARM rates often feature a premium above a certain interest rate index, such as the London Interbank Offered Rate. For example, your option ARM may add five percent to twelve-month LIBOR to calculate its monthly interest rate.
Option ARMs typically begin with a period of low fixed, or teaser rates to attract borrowers. Teaser rates often last for time frames of between 12 and 60 months, before shifting higher to match current market conditions. At that time, scheduled payment amounts will likely increase substantially.
Option ARMs are aptly named because they extend four separate payment options during an introductory period. You may elect to make 15- or 30-year amortization payments. These payments are calculated monthly and would enable you to pay off the loan in 15 and 30 years, respectively. Interest-only and minimum payments are two other options. Interest-only payments strictly meet interest expenses and do not repay any loan principal. Additionally, minimum payments actually allow you to pay less than your loan’s monthly interest expense.
The option ARM introductory period may expire after five years. After that point, the loans recast and you must pay full principal and interest payments to pay off the loan within the next 25 years.
Option ARMs are more so ideal for sophisticated real estate investors and other upwardly mobile homebuyers that face irregular income patterns. For example, a medical resident or junior attorney may both expect their respective incomes to significantly increase within the next five years.
Option ARMs, however, do expose owners to severe payment risk. In some cases, a recast of the mortgage will be impossible to afford, which would ultimately trigger foreclosure.