A payment option ARM is an adjustable rate mortgage whereby the borrower has the option of choose one of several payment plans.
These can include:
- Fully amortizing monthly payment
- Interest only monthly payment
- Minimum monthly payment
A home loan that is structured this way allows a borrower to adjust monthly repayment obligations base on his wage and salary.
This means that even if a homeowner is doing odd jobs, he should still be able to meet the minimum payment requirement which is calculated from a temporary start interest rate.
The problem with this setup is that when payments does not fully cover the interest incurred, especially with the interest-only option, deferred interest arise which will create negative amortization if left unchecked.
Because for the target market that loans like these were conceptualized for, lender have an above average expectation that borrowers would run into situations of negative amortization.
So they have allow it to occur but set limits on it.
Usually when a payment option ARM has negative amortization that hits a certain limit, it will trigger a recast of the loan.
While the goal of helping people become homeowners which they otherwise could not, the creation of payment option ARMs should be applauded.
But like many non-conventional mortgages they present a high risk of borrowers taking on loans that they cannot realistically afford.
Borrowers need to evaluate how much home they can afford before making such debt commitments.
However, these loans can be attractive for short term financing, especially when a real estate investor is trying to flip a house quickly.
The underwriting of such loans were rampant in the period leading up to 2008.