Option-adjustable-rate mortgages

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Option adjustable rate mortgages (ARMs) are adjustable rate mortgages that offer several different repayment options to borrowers. As with other adjustable rate mortgages, the interest rate on the mortgage changes, rather than being fixed. This means that when interest rates go down, so does the interest rate on the mortgage, but when interest rates rise, the mortgage interest rate also goes up.

To compensate for the changes in the interest rate, the payments are periodically recalculated or “recast”, meaning that the amounts of the mortgage payments can vary from year to year, and sometimes month to month.

They are often touted as being highly flexible and useful for people who are trying to buy a first home, especially in the case of people with growing incomes. However, there are some serious dangers to an option ARM which should be carefully considered before committing to this type of loan. They often start out with a low introductory rate, but when the rates are recast, monthly payments can rise sharply to compensate for changes in the interest rate, giving borrowers payment shock.[1]

One big danger of option ARMs is that they allow negative amortization, meaning that the borrower can pay less than the accrued interest every month, and that unpaid interest is added to the principal balance. Over time, the loan grows larger, rather than becoming smaller with the monthly payments. If an option ARM does become a negative amortization mortgage, the bank may recast the rates to keep the borrower on track, causing a jump in monthly payments.

References

  1. What are Option ARMs?. Wisegeek.com.