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- Last Updated: Wednesday, 23 January 2019

They're called pay option loans, pick a payment, and the somewhat less descriptive term Option ARMs. Regardless of the name, these innovative mortgages can save borrowers 30% or more on their monthly payments; but at what cost?

In this article, we're going to first explain how an Option ARM works, including defining the terms associated with this type of mortgage. Next, we'll talk about the growing demand for flexible payment arrangements, and how these exotic mortgages helped to fuel the growth of the subprime lending market. Then we'll finish up with an example, demonstrating the impact this type of mortgage can have on a borrower's monthly payments, as well as their long-term consequences.

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By definition an adjustable rate mortgage, or ARM, is a loan where the interest rate is adjusted periodically based on a pre-defined index. The word "option" refers to the added payment flexibility these loans offer homeowners. With an Option ARM, the borrower has the choice of making one of several payment types. For example, the borrower might pay:

- A minimum payment
- An interest-only payment
- A fully amortizing, or fully indexed rate

As we'll see later on, these loans are growing in popularity due to their built-in flexibility, and their ability to keep mortgage payments low.

The exact terminology encountered with this type of loan will vary by lender. But the concepts should help consumers to get a fundamental understanding of how these loans are structured. At the most basic of levels, an Option ARM has three major features:

- Varying interest rates
- Flexible monthly payments
- A recast cap / mortgage

Each of these components is explained in more detail in the sections below.

Whereas most fixed rate mortgages will quote just a single interest rate on the loan, an ARM has an adjustable rate; one that is tied to a published interest rate index. As this index varies over time, so does the rate paid on the ARM.

An Option ARM takes this concept one step further. In fact, there are multiple rates bundled with this type of loan:

**Start or Teaser Rate**: the starting rate for the loan, which is also the lowest published rate. The start rate is also referred to as the teaser rate because of its attractiveness to the home buyer.**Index Rate**: a published financial index such as LIBOR (London Interbank Overnight Rate), 12-MTA (Monthly Treasury Average), CODI (Cost of Deposits Index), COFI (Cost of Funds Index), or COSI (Cost of Savings Index). As the index changes over time, so will the rate on the loan (as discussed later on).**Margin Rate**: the difference between the mortgage's actual interest rate and the index rate. The lower the margin rate, the better the loan from the borrower's perspective.**Fully Indexed Rate**: the interest rate used to determine a fully-amortized mortgage. The fully index rate is equal to the Index Rate plus the Margin Rate.

Before a mortgage is recast (more on that later), the borrower has the option of making three payment types. Each of these payment types has a different effect on the principal of the loan.

**Minimum Payment**: based on the starting, or teaser rate. For example, if the start rate is 2.750% on the loan, then the minimum payment will be based on this rate.**Deferred Payment**: when the borrower makes a minimum monthly payment, the principal on the loan grows, and the loan is said to be in a negative amortization or NegAm situation. Negative amortization occurs because the minimum monthly payment does not cover the full cost (in terms of financing) of the loan.- I
**nterest-Only Payment**: a second option the borrower has is to make an interest-only payment. When this occurs, the borrower is only covering the interest charges on the loan, the principal is not decreasing. The interest rate for this payment is equal to the Index Rate plus the Margin Rate. **Fully Amortizing Payment**: the final option is to make a fully amortizing payment. The interest charged for this payment is the same as in the case of the interest-only payment. But unlike the interest-only payment, the fully amortizing payment allows for the pay-down of the principal balance; just like a conventional mortgage.

As mentioned earlier, an Option ARM allows the borrower to make minimum monthly payments. With this type of arrangement, a deferred payment occurs because the monthly funds are not large enough to cover the total cost of the loan. If the borrower continues to make minimum payments, the loan will grow until it is eventually recast.

The terminology associated with recasting includes:

**Recast Cap**: the threshold at which the Option ARM is recast, and is converted to a conventional mortgage. The recast cap is stated in terms of percentage of the original loan, and is always greater than 100%. The higher the recast cap, the longer the mortgage is allowed to grow.**Recast Period**: an estimate of the time that will elapse, at the minimum payment value, before the recast cap is reached. The recast period is usually stated in months.**Recast Mortgage Amount**: the total value of the recast mortgage. This value is found by multiplying the recast cap times the original mortgage principal. For example, if the recast cap is 125% and the original mortgage is $100,000, then the recast mortgage amount is 125% times $100,000 or $125,000.**Recast Monthly Payment**: once the mortgage is recast, it behaves more like a standard ARM, meaning it is a fully amortizing loan. The recast monthly payment is calculated based on the fully indexed rate and the recast mortgage amount.

The flexible pay options featured in these loans make them attractive to many borrowers. The controversy around these mortgages stems from the aggressive marketing efforts of brokers to the subprime market; those individuals with weak credit reports or scores.

A problem occurred because many owners of these loans were making minimum payments each month, and were therefore in a negative amortization situation. As long as home prices continued their upward movement, negative amortization was not a problem. The outstanding principal on the mortgage was increasing, but the value of the home was increasing too.

The exotic mortgage market began to unravel when home prices started to decrease. This decrease, coupled with negative amortization, led to a rapid decrease in the homeowner's equity. At the extreme, borrowers found themselves with homes that were worth less than what they owed lenders.

Despite its drawbacks, there are some situations where this mortgage is appropriate, for example:

- The borrower might be expecting a large inheritance that can be used to pay off the loan.
- The borrower expects their income to rise quickly as their career progresses or another family member enters the workforce.

As promised earlier we're going to finish this article with an example that explains how the above-mentioned concepts fit together. This particular example was calculated using the Option ARM calculator found on this website. In fact, this is the default scenario.

In this example, Bill has a home loan of $200,000, a start rate of 2.750%, an index rate of 3.750%, and a margin rate of 3.500%. Bill also agreed to a recap rate of 110% and a loan term of 30 years.

With these terms and conditions, the minimum mortgage payment turns out to be $816.48. The interest-only payment is $1,208.33, and the deferred payment (negative amortization) is $391.85 each month. If Bill continues to make these minimum payments, his recast period would be 51 months. At that time, the recast mortgage would be $220,000, and the recast monthly payment would be $1,573.94.

By comparison, if Bill had decided to take out a conventional mortgage for 30 years at a fixed rate of 8.000%, his monthly payment would be only $1,467.53; a savings of $106.41 over the Option ARM. Furthermore, this homeowner would have an outstanding principal balance of around $192,000 after 51 months, compared to the $220,000 for the recast mortgage. In this particular scenario, a homeowner choosing the fixed rate mortgage would have nearly $30,000 more equity in their home.

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