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Option ARM

Mortgage Library: Types of Mortgage Loans: Option ARM

This loan program is an adjustable rate mortgage with added flexibility of making one of several possible payments on your mortgage every month, in order to better manage your monthly cash flow.

It's low introductory start rate allows you to make very low initial mortgage payments and low qualifying rates enable you to qualify for more home.

The minimum payment option can help keep your monthly payments affordable. If the minimum monthly payment is not sufficient to pay the monthly interest due, you can always avoid deferred interest by choosing the interest-only payment option.

With the Option ARM, you generally have at least two fully amortized payment choices, leading to a quicker loan payoff. If you prefer to pay off your loan on schedule, you can make the fully amortized payment based on a 30-year loan, or you can choose the 15-year payment option for the fastest equity build-up.

In most cases, you can also make additional principal payments which reduce the amount you need to pay in later months.

Option ARM loan programs are right for you if you'd like to own your property only for a short time, and prefer affordability and flexibility in your monthly payment. However, if you select the minimum payment option in the early years, you should be prepared for a possible sudden increase (often referred to as payment shock) in your monthly payments thereafter.

Option ARM loans have four major types of payment options:

  • Minimum Payment

    With the minimum payment option, your monthly payment is set for 12 months at your initial interest rate. After that, the payment changes annually, and a payment cap limits how much it can increase or decrease each year.

    If you make the minimum payment after the end of your initial interest rate period, which usually holds only for the first 1 to 3 months, it may not be enough to pay all of the interest charged on your loan for the previous month and the unpaid interest will be added to the principal balance you owe (will be deferred).
     
  • Interest-Only Payment

    With the interest-only payment option, you can avoid deferred interest, when the minimum payment is not enough to pay the monthly interest due. The interest-only payment option, however, is not available if the interest-only payment would be less than the minimum payment. Please note, that this payment option does not result in your principal reduction.

    The interest-only payment may change every month based on changes in the ARM index used to determine your fully indexed rate.
     
  • Fully Amortizing 30-Year Payment

    With fully amortizing payments, you pay both principal and interest and keep your loan on schedule. Your payment is calculated each month based on the prior month's fully indexed rate, loan balance and remaining loan term.
     
  • Fully Amortizing 15-Year Payment

    If you prefer to put your loan on an accelerated schedule and can afford higher monthly payments, the 15-year payment option allows you to repay your loan twice as faster and save more than half the total interest costs of a 30-year loan.

    Please note, that this payment option is offered only on the 30-year (or 40-year) term. It will cease to be an option when the loan has been paid to its 16th year.

These options should be clearly marked on your loan statement, so it is very easy to figure out how much you should pay each month. Just enter the correct amount in the payment coupon section of your statement.

Option ARM loan programs are becoming more and more popular today, and there are many variations of this innovative home financing product on the market: PayOption ARM, CashFlow Option Loan, 1-Month Option ARM, Flex 5 Home Loan, Pick-a-Paymentsm Loan, 12 MAT ARM, Option Power ARM, FlexPay® 12 MAT, FlexPay® 3/1 LIBOR ARM, OptPAY ARM, etc. If you are thinking about applying for an option ARM, it is important to shop carefully and investigate several loan products, to find the one best for you.

Option ARM loan programs may vary in the initial rate, negative amortization and lifetime caps, ARM index, or optional features, however, when comparing one option ARM with another, pay close attention to the margin and the fully indexed rate. Keep in mind that the initial interest rate holds only for the 1st month.

What features to compare with different Option ARM loans?

Loan Term

Option ARM loans are available for 30 or 15 years. *

Initial Interest Rate (Note Rate)

Your Minimum Payment Rate or 'Start Rate'. It may vary from 1.25% up to 3.95% and depends on your Loan-to-Value Ratio (LTV).

With hybrid option ARMs, that use a different minimum payment calculation method, your initial rate is usually higher.

Initial Interest Rate Period (Introductory Period, Initial Fixed-Rate Period)

Option ARM loans are available with an initial introductory period, usually of 1, 3 or 6 months, after which the interest rate may change.

Notes:

  • Some option ARM are currently offered without any introductory period, so the fully indexed rate (FIR) is effective immediately.
  • The initial Fixed-Rate Period should not be confused with Initial Fixed-Rate / Fixed-Payment Period, a typical feature of hybrid option ARMs.

Examples:

  • With 1-month option ARMs that have a 1-month introductory period, the first interest rate change occurs when the 1st monthly payment is due. Thereafter, the interest rate may change monthly. 
  • If you have a 1-month option ARM loan with a 3-month introductory period, the first interest rate change occurs when the 3rd monthly payment is due. Subsequent interest rate changes may occur each month thereafter.
During the introductory period: After the introductory period:
Monthly Payment = Minimum Payment
Interest Rate = Start Rate
Monthly Payment = Minimum Payment
or Interest-Only Payment
or Fully Amortizing 30-Year
or Fully Amortizing 15-Year
Interest Rate = Fully Indexed Rate
Periodic adjustments after the introductory period:
Event Loan Feature Change Frequency Cap
Monthly Interest Rate Adjustment Fully Indexed Rate Monthly Lifetime Cap
Annual Minimum Payment Change Minimum Payment Annually Payment Change Cap
Loan Recast Minimum Payment Every 5th Year None
Other adjustments:
Event Loan Feature Change Frequency Cap
Loan Recast (negative amortization limit is reached) Minimum Payment Irregularly None

Fully Indexed Rate (FIR)

The sum of the margin and the most recent index figure available prior to a scheduled interest rate change date. Subject to the interest rate caps.

Note: Your interest rate can be equal to the index rate plus the margin exactly, or it can be rounded to the nearest one-eighth of one percentage point (.125%).
Example:
Index: 0.118 (MTA as of July 2014)
Margin: 2.75%
Fully Indexed Rate ('as it is'): 2.868% ( = index + margin )
Fully Indexed Rate (rounded to the nearest 0.125%): 2.875%

Fully Indexed Rate (FIR): Sum of the Margin and the Index.

Interest Rate Adjustment Period

The time between interest rate adjustment dates.

With option ARMs, the adjustment period is usually set to 1 month: the fully indexed rate may not change more than once every month based on the movement of the index.

Maximum Rate (Interest Rate Ceiling)

See: Lifetime Cap.

Lifetime Cap

A lifetime cap limits the interest rate increase over the life of the loan. It protects you financially and usually is expressed as maximum rate. Lifetime caps may vary from 9%-10% up to 19%.

Lifetime Floor (Life Floor, Lifetime Rate Floor)

The lifetime floor is never lower than the margin. See: Margin.

Minimum Payment

Initially (for the first 12 months), the minimum payment is calculated using the start rate, the amount you borrow and the loan term. Thereafter, it is recalculated annually.

Example:
Loan Amount: $200,000.00
Initial Rate: 1.25%
Index: 0.118 (MTA as of July 2014)
Margin: 2.75%
Payment Cap: 7.5%
Fully Indexed Rate: 2.868% ( = index + margin )
Fully Indexed Rate (rounded to the nearest .125%): 2.875%

Minimum Payment Changes:
Year 1 $666.50 = Base of Minimum Payment
Year 2 $716.49 = $666.50 + 7.50%
Year 3 $770.22 = $716.49 + 7.50%
Year 4 $827.99 = $770.22 + 7.50%
Year 5 $890.09 = $827.99 + 7.50%

Minimum Payment Adjustment Period

The minimum payment adjustment period is usually set to 12 months, unless negative amortization limit is reached.

Minimum Payment Change Cap

A limit on how much the minimum monthly payment can change at each adjustment. With most option ARMs, your payment cap will be 7.5% of minimum payment amount in first five years. It means that on any Payment Change Date, the minimum payment cannot increase or decrease by more than 7.50% (unless the loan is
recast or the negative amortization limit is reached).

Note: With some loans, the minimum payment is subject to a 7.5% increase with no limit on the decrease (in a declining interest rates environment).

Negative Amortization Cap (Balance Cap, Negative Amortization Limit, Negative Amortization Ceiling)

It limits the loss of equity in your home when low monthly payments do not cover fully the interest rate charges agreed upon in the mortgage contract and is usually set to 110% - 125% of your original principal balance.

 When the negative amortization limit is reached, the minimum payment increases immediately: the payment required to fully amortize the loan over the remaining term becomes the new minimum payment, and the payment cap does not apply.

Payment Recast Period

Recasting (or re-calculating your loan) is another way of limiting negative amortization and keeping your loan on the original schedule. The main purpose of recasting is ensure the loan is paid off within the scheduled amortization period.

Option ARM loans are usually recast every five or ten years (or sooner, if the negative amortization limit is reached). This re-calculation (or re-amortization) is based on the outstanding principal balance, the remaining term and the fully indexed rate.

When the loan is recast, the payment required to fully amortize the loan over the remaining term becomes the new minimum payment, and the payment cap does not apply (the payment cup, however, will go back into effect immediately after the recast, and will hold until the next time your loan is recast).

Standard 5-Year (10-Year) Recast vs. Negative Amortization Limit Recast

The 1st Standard 5-Year Recast occurs when the 61st payment is due.

Subsequent Standard 5-Year Recasts occur each 60 months thereafter.

A new minimum payment is calculated for the payment due on the 61st month based on the fully indexed rate at that time, the remaining term of the loan and the loan balance at that time. There are no other payment options for this (61st) month. This new recast payment becomes the new minimum payment for the upcoming 12 months subject to a 7.5% (or whatever your payment cap is) increase the following 12 months and subject to a full recast 5 years from this payment recast, i.e. when the 121st payment is due.

The 1st Negative Amortization Limit Recast occurs when (or if) the negative amortization cap is reached. The loan is automatically recast for the remaining portion of the standard recast term (5 years) and then subject to recast at the normal scheduled (5 year) recast period.

For example, if the loan reaches the negative amortization cap on month 59, the loan goes through a Negative Amortization Limit Recast. At the end of the 5th year, on the 61st month, the loan goes through a scheduled Standard 5-Year Recast.

Index Options

Your interest rate is usually based on one of the following indexes:

These indexes change once a month.

Click on index title for explanations. Click here for current and historical values.

Historical performance of the four most popular option ARM indexes over the last 14 years.
Historical performance of the four most popular option ARM indexes over the last 14 years.

Generally, lenders use the most recent Index figure available as of the date 15 days before each interest rate adjustment date. This Index value is called the 'Current Index'.

Margin

The number of percentage points (for example, 2.75) the lender adds to the index rate to calculate the ARM interest rate at each adjustment. The margin is set in the mortgage contract, remains fixed for the term of the loan and is not impacted by the financial markets and movement of interest rates.

Caps

Option ARMs don't have First Interest Change Cap or Periodic Interest Change Cap*. Initial and periodic interest rate changes are not capped and move with the market, as long as the rate adjustments do not exceed the lifetime cap. The interest rate cannot adjust lower than the lifetime floor.

Option ARM loans have:

* This is not the case with so-called hybrid (combined) option ARMs. Hybrid option ARM loan programs usually have both First Interest Change Cap and Periodic Interest Change Cap, however, their minimum payment adjustments are not capped (i.e. there is no Payment Cap). Both hybrid and standard option ARMs have Balance Cap (a. k. a. Negative Amortization Limit).

Documentation Types

Full doc, Limited doc, Low doc, Stated Income, No Income\No Asset (NINA), Stated Income\Stated Assets (SISA). Read more about Loan Documentation Requirements. Click here for a list of documents most lenders will require in order to process your mortgage application.

Loan Program Variations / Options / Special Features

Initial Fixed Rate Period

Option ARM loans may have an initial fixed rate period between the time the loan is originated and the first interest rate change date. After the initial fixed period the loan usually converts to a monthly-adjustable option ARM. Hybrid Option ARM loan programs have either an initial fixed payment period or an initial fixed rate / fixed minimum payment period of 3 to 7 years.

40-Year Term

Some option ARM loans, for a fee (or for an increase in your rate), contain a provision permitting you to increase the term of the loan from 30 to 40 years.

Bi-Weekly Payments

Some lenders offer optional bi-weekly payment plans with option ARMs. With bi-weekly mortgage plan you pay half of the monthly mortgage payment every 2 weeks. It allows you to repay a loan much faster. For example, a 30 year loan can be paid off within 18 to 19 years.

Conversion Option

The interest rate or points may be somewhat higher for a convertible option ARM, and it also may require a small fee at the time of conversion.

Option ARM Calculator { See also: Advanced Option ARM Loan Amortization Calculator }

Loan Amount: $
Initial Rate: %
Index: 0.118 (MTA as of July 2014)
0.154 (1-Month LIBOR as of July)
0.668 (COFI as of July)
4.790 (COSI as of September)
Other:
Margin: %

Fully Indexed Rate: 2.868% ( = index + margin )

  • Minimum Payment: $666.50
  • Interest Only Payment: $478.00
  • Fully Amortizing 30-Year Payment: $829.04
  • Fully Amortizing 15-Year Payment: $1,368.50
  • Fully Amortizing 40-Year Payment: $700.84

Mortgage Professionals Offering Option ARM Loans

In this article we have described only some of the features offered with option ARM loan products. If you are looking for an option ARM and need more information or advice, we invite you to take advantage of our database of the most competitive lenders, brokers and loan consultants available. Just complete a short loan request form and the best mortgage professionals in your local area offering option ARM loan programs will contact you with their rates and fees.

FlexPay® is a registered trademark of IndyMac Bank, F.S.B and/or its subsidiaries. Pick-a-Paymentsm is a service mark of World Savings. CashFlow Option Loan, Flex 5 Home Loan, and all other trade/service marks are the property of of their respective owners.


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