Option Adjustable-Rate Mortgage - Option ARM

“Option adjustable-rate mortgages,” or option ARMs, became all the rage back in 2004. On the surface, they sure can look like a good deal: we get a nice, low introductory interest rate on the loan for the first few years or so, and not only that, we have a bunch of options for how we want to pay our mortgage every month. Low rates and flexible payment options? Sounds like a dream, right? After all, if our interest rates are low and we have the option of not making a full payment every month, then we can afford to get a nicer house in a better neighborhood.

But let’s back up to that part about not making a full payment for a sec. One of the most enticing things about option ARMs is also one of its most dangerous. When we have an option ARM, we can typically choose to make one of three types of payments every month. First, we can pay the principal and interest that are due for the month in full. This is ideal, and is how most traditional mortgages work. If we can’t quite swing that this month, we also have the option of just paying the interest. This is less ideal, because we’re not paying down the principal of the loan, and as a result, it’s just going to incur more interest that we’re eventually going to have to pay off as well. But if we’re in a real financial jam one month, we might decide it’s worth it to do it anyway. The third option is the minimum payment option, which allows us to make an itty bitty monthly payment that doesn’t quite cover the interest due and certainly doesn’t pay down the loan’s balance. This is pretty much the worst thing we can do, other than paying nothing at all. We’re not paying down the loan, we’re not paying down the interest, and now we’re going to end up paying interest on interest. The overall amount we owe is increasing, not decreasing, and if the value of our new home isn’t also increasing, we’re going to find ourselves upside-down on our mortgage and potentially in danger of losing the house. This is bad, bad, bad.

It’s so bad, in fact, that economic analysts tend to give option ARMs a big ol’ frowny face accompanied by two thumbs down. In fact, many of them say option ARMs are partially responsible for the subprime mortgage crisis of 2007-08: as housing values fell and the job market deteriorated, people who probably shouldn’t have gotten approved for big mortgages anyway found themselves unable to make loan payments and unable to sell their home for anything near what they’d paid for it. Not only that, but remember that nice, low introductory interest rate we mentioned? Yeah, that’s only in effect for the first few years of our mortgage. Once that rate expires, the mortgage adjusts to the current market interest rate, which is, of course, much, much higher than the intro rate. This means the mortgage payments themselves are much higher, and if we’re consistently making minimum or interest-only payments on the loan, those higher rates can mean we’ve signed up for a mortgage we’ll never be able to pay off.

But look, it’s not all doom and gloom in the option ARM world. There are homeowners out there who can really benefit from this type of mortgage. Like...let’s say we make a quite decent amount of money and are certain we can pay off the mortgage in its entirety before the introductory interest rate expires, or soon thereafter. Or let’s say the payment options appeal to us because, even though we make enough annually to comfortably make our mortgage payments, our income isn’t the same from month to month. An option ARM gives us the choice to make a full payment this month, an interest-only payment the month after, and then a double payment the month after that to make up for the second month. So that can be helpful. But by and large, if we’re considering buying a house or refinancing an existing home loan, we should definitely read all of the fine print—and make sure we can actually afford the loan—before we sign on any dotted lines.