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One loan that provides a lot of flexibility is called an option ARM (ARM stands for adjustable rate mortgage), also referred to as a pay option ARM or a flexible payment ARM. There are several types out there and if you're considering an option ARM, it's important to choose the right one or you can get yourself into trouble. Option ARMs are a type of adjustable rate mortgage (ARM) and allow you to choose between four payment options each month, whichever best fits your needs. You can choose from a minimum payment, an interest-only payment, a 30-year or a 15-year amortization payment. These payment choices can be good for people who are going through a major life change such as divorce or those whose income is not fixed, such as salespeople or wait staff. If you have a month where you don't make as much money and have trouble paying your bills for that month, you could choose to make the minimum payment or the interest-only payment. Then, when things pick up, you can afford to make the 15- or 30-year payment. It can also be a good type of loan if you're a serious investor and want to put more money toward a particular investment when you choose. But how do the different payment options work? Interest-Only Payment The interest-only payment is equal to the amount needed to repay the interest due each month. Just like any other interest-only loan, you're not paying any principal balance for a certain time period, but you're paying enough to cover the interest. 15-Year and 30-Year Amortization Payment If you decide to make the 15-year or 30-year amortization payment, you're paying an amount that is needed to pay off your loan in 15 or 30 years (respectively) from the date you closed your loan. The 15-year payment is the higher of the two and it pays down your loan's principal balance the fastest. Minimum Payment The minimum payment is the most complicated one. It is the lowest payment option and covers an amount less than what it would take to pay the full interest in a given month. So, if you have a $100,000 loan at 6.25 percent, the interest equals $520.83. Depending on how your minimum payment is calculated, your minimum payment would be less than that. Generally speaking, your minimum payment may change each year, but it can only increase a certain percentage of the previous year's minimum payment amount. Every five years, your loan gets recalculated to help you stay on track to pay off your loan. After each recalculation, your new minimum payment is based on your current interest rate, your unpaid principal balance and your remaining loan term. This is also known as a negatively amortizing or deferred interest loan and can become dangerous. If you only pay the minimum every month, you're not paying off the full interest. You're deferring it to a later time. The amount of interest that isn't paid gets added to your loan balance and it doesn't take that long for your loan balance to exceed the original loan amount. Put simply, you could end up owing much more than when you started. However, there are some option ARMs out there that are not as dangerous as that. Some give you a fixed rate and calculate your minimum payment based on your interest rate minus a percentage for the first five years until it reaches the maximum deferred interest level of about 115 percent. This type of option ARM then becomes a six-month fully-amortizing ARM. When that happens, the loan loses its potential to be a negatively amortizing loan. Benefits of Option ARMs An option ARM can give you the benefit of a lower rate because it's an adjustable rate mortgage. The introductory rates for this type of loan program can be as low as one percent. Plus, you also have the ability to choose which type of payment you want to make, depending on your financial situation for a given month. The minimum payment can significantly help you if you need more cash for other things, like consolidating high-interest credit card bills or investing more in your 401k. The 15-year payment can help you pay off your loan faster, if that's your goal. However, many lenders charge penalty fees for paying off your loan early and some don't, so check with your lender. There are many option ARMs available and if you're considering getting one, you should be someone who can actively and intelligently manage your finances. Be sure to talk to an experienced mortgage banker who can answer all your questions and make you feel at ease about your choice. And look for an option ARM that gives you the flexibility you need, yet can't get you into too much financial trouble. * Please consult your tax advisor.
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