The Option ARM loan can be a great product for some people, but most consumers don't fully understand them. Here is a description of the loan and how it works.

The loan typically starts out with a low initial interest rate, usually around 1%. The initial rate can be fixed for anywhere from 1 month to 5 years. The rate on an option ARM is adjusted monthly, but the minimum payment is adjusted annually and remains fixed for a year. If rates rise afterward, the minimum payment doesn't cover all of the interest charged. When that happens, you owe more on the mortgage at the end of the month than at the beginning of the month, even after making that minimum payment. This phenomenon is called negative amortization.

The Option ARM has 4 payment types, which gives borrower flexibility from month to month. These payment types are as follows:

1) A Minimum monthly payment (based on your initial interest rate, lets assume 1%). Typically, this minimum payment cannot rise more than 7.5% per year.

2) An interest only payment based on the current interest rate of the loan.

3) A fully amortized 30 year principal and interest payment.

4) A fully amortized 15 year principal and interest payment.

The potential danger of this loan is that people tend to use it to buy something they otherwise couldn't afford. If you buy a home and can only afford to make the minimum monthly payment (option #1 above) on the Option ARM product, then this loan is not for you. Over time, your mortgage balance will continue to go up, not down, and soon you will owe more money than you initially borrowed. Hence the term negative amortization.

That being said, these loans can be excellent for the right person. If your income tends to fluctuate throughout the year, this loan will allow you to adjust your mortgage payments to match your income throughout the year. Also, if you are not planning to stay in your home for an extended period, this may be a good option for you.

Some lenders now have the option of switching your Option ARM mortgage to a fixed rate mortgage for a nominal fee. In this rising interest rate environment, this should be an important consideration when choosing a lender if you decide to go with one of these loans.

This is also a good loan for investors who will be flipping the property several months down the road and just want to keep their mortgage payments low in the mean time.

As mentioned above these payments are ideal for someone who has fluctuating income. This is why this type of loan scenario is often called a Pick Your Payment program. Another great use of this program is for investors who invest in markets where the appreciation level is strong. The lower payments increase cash flow while the appreciation beats the negative amortization.

The payment flexibility is also ideal for rental property owners. While the property is occupied owners can afford to make interest only or the 30 year payment. If there is a period of time when the property is unoccupied, the owner can make a minimum payment to avoid having the burden of a full payment. The minimum payment can also be utilized in times of repair. Should the tenant report a faulty system that needs extensive repair, the owner can use a minimum payment option to absorb a portion of the repair cost.

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 holds only for the first month, 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).
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.