4 Things to Watch Out for with an Option ARM Mortgage

The option ARM mortgage has become very common in the mortgage market today. Even though many people use these mortgages, there are some potentially negative features involved with them. Here are a few things to watch out for with an option ARM mortgage.

1. Low Teaser Rates

The first thing that you will want to watch out for with this type of mortgage is a low teaser rate. Many times, these mortgages will publish an interest rate that sounds very appealing. In most cases, this rate seems like it is too good to be true. Many times, the rate will be one or two percent. This is typically much lower than what you will see on any other loan in the marketplace. Most of the time, this introductory rate does not last for very long. Sometimes you will receive that interest rate for only the first month or two of the loan. After that, the interest rate goes up significantly. Many people make their decision to get a mortgage based upon the low introductory rate instead of what the rate will jump up to after the introductory period is over. Make sure that you understand how this works and that you look at the long-term consequences of the loan instead of saving some money on the front end.

2. Negative Amortization

Another big problem with option ARM mortgages is negative amortization. Negative amortization occurs when you make a payment that is less than the amount of the accrued interest for the month. The option ARM mortgage is sometimes referred to as the "pick a payment" mortgage because you can make a minimum monthly payment that is often lower than the interest on the loan. When you do this, the amount of interest that you do not pay is added onto the principal of the loan. This is referred to as negative amortization.

3. Swollen Principal

As a result of negative amortization, you will have to deal with a swollen principal. The principal balance is going to get bigger and bigger when you do not pay the interest. Many of these mortgages have a maximum amount that the principal can get to before the lender stops allowing you to make minimum payments. For example, the lender might allow your balance to get up to a maximum of 110 percent of the loan before stopping you. At that point, the smallest payment that you can make might be more than you can afford.

4. Built-in Recalculation Period

Another thing that you will have to deal with is the built-in recalculation period. At a certain point after you begin the loan, the lender is going to recalculate your monthly payment and the loan. For example, at the end of five years, they might recalculate the loan based on your new loan balance. You will not have the option to make minimum payments or interest-only payments at this point. You will have to pay principal and interest on the entire balance over a shorter period of time. This means that your payment could suddenly increase significantly.