Option Adjustable-Rate Mortgage

Definition

An Option Adjustable Rate Mortgage (Option ARM) is a type of adjustable-rate mortgage where the borrower can choose the type of payment to make to the lender. Besides the option to make interest and principal payments to reach the regular mortgage payment amount, an option ARM offers another payment choice, significantly reducing the payment amount by paying only interest or a minimum payment.

Origin

The Option ARM originated in the United States during the 1980s when financial markets began offering more flexible loan products to meet the needs of different borrowers. This type of loan became more popular in the early 2000s, especially during the housing market boom.

Categories and Features

Option ARMs typically offer three payment options: full payment, interest-only, and minimum payment. Full payment includes both principal and interest, similar to traditional mortgages. The interest-only option allows borrowers to pay only the interest, reducing monthly payments but not the principal. The minimum payment option can lead to negative amortization, where the loan balance increases because the payment amount is insufficient to cover the interest.

Case Studies

In the early 2000s, Countrywide Financial in the U.S. offered a large number of Option ARMs, attracting many borrowers to choose the minimum payment option. However, as interest rates rose and home prices fell, many borrowers found their loan balances increasing, leading to financial difficulties. Another example is Washington Mutual, which also widely offered these loans during the housing boom, ultimately suffering significant losses during the financial crisis.

Common Issues

Common issues investors might face with Option ARMs include the risk of negative amortization and increased payments due to rising interest rates. Borrowers often misunderstand the long-term impact of the minimum payment option, potentially leading to a higher debt burden.