Understanding how payment-option ARMs work will help you determine whether this type of mortgage is the right choice for you.
Definition and Example of a Payment-Option ARM
A payment-option ARM is an adjustable-rate mortgage with multiple payment options. These options include:
Traditional payments: If you choose traditional payments, you’ll pay enough each month to cover both your principal and interest. You can choose either 15-, 30-, or 40-year fully amortizing payments. Amortization prioritizes interest payments over principal payments, slowly transitioning to paying more on your principal than in interest over time.Interest-only payments: You can also choose to make interest-only payments. This won’t change the amount you owe on your mortgage, but it won’t pay down your principal either.Minimum payments: You can choose to make minimum payments, which means you pay a portion of the interest. That means any interest you don’t pay will be applied to the principal.
When you first take out a payment-option ARM, your payments are calculated based on a temporary starting interest rate. When the temporary rate is in effect, you can’t switch to another payment option. Once the temporary starting rate expires, you have the option to switch to another payment option, such as a minimum payment.
How a Payment-Option ARM Works
When you take out a payment-option ARM, you can choose between several different payment options, including payments that cover principal and interest, interest-only payments, or minimum payments that only cover a portion of your interest. Payment-option ARMs appeal to some borrowers because they can be more affordable initially. For example, say you took out a $200,000 mortgage with a 30-year term and a starting interest rate of 4%. If you choose a fully amortizing ARM, your starting payments will be $954.83 per month. If you select interest-only payments, your starting payments will be $666.67. That will save you $288.16 per month, but you won’t be making any progress on paying down your mortgage. A payment-option ARM’s interest rate will eventually adjust. Your interest rate will likely change, and your monthly payments will go up. This could lead to significant payment shock; it is possible for your payments to triple.
Pros and Cons of Payment-Option ARMs
Pros Explained
Affordable payments: In the beginning, choosing a payment-option ARM will help you lower your monthly payments. This could make it a more affordable option for new homebuyers. Flexible payment terms: Once the starting interest rate expires, you can switch to another payment option. This can provide more flexibility for borrowers on a limited budget. Payment caps: More ARMs come with payment caps, limiting the total interest on your mortgage. Payment caps can provide some security since you know your interest will never go up beyond a certain point.
Cons Explained
Higher loan balance: When you take out a payment-option ARM, your payments may not cover the full amount of interest you owe. This negative interest is added to the loan balance—your principal—resulting in a higher loan balance than you originally borrowed.Payments will go up and down: Your payments will vary over the loan term because the interest rate is adjustable. Your payments may be low initially, but they could eventually go up by a lot once the payment adjusts. Lenders refer to this as “payment shock.”
