Option Loan Explained

A mortgage option loan is a unique type of mortgage that allows you greater flexibility with your payments. An option loan can afford you the ability to pay a home with very low monthly payments for a set period of time. However, option loans generally end up costing you more in interest over the life of the loan and your payments can rise dramatically and suddenly at the end of a set term, making it difficult to afford your loan unless your income increases significantly or you can refinance.

How Does a Mortgage Option Loan Work?

A mortgage option loan is a form of adjustable rate mortgage, or ARM. However, unlike a standard ARM where your monthly payment is based on an interest rate that is tied to a financial index and adjusts periodically, under an option loan you have several different options for repayment.

An option loan differs from a traditional ARM because your interest rate adjusts monthly, as opposed to a more traditional ARM, which usually adjusts at fixed intervals. An option loan also differs from a traditional ARM because you can change your payment method annually, thereby dramatically altering the amount you pay each month.

Why Choose an Option ARM

Buyers generally select an option ARM because they are offered a very low initial promotional interest rate- sometimes as low as 1 percent. However, this interest rate generally only lasts for a small amount of time, usually one to three months. At the end of that time, interest rates adjust according to the index specified in the loan agreement.

Payment Methods for a Mortgage Option Loan

Under a mortgage option loan, you can choose from one of four major repayment methods:

• Interest only payment option: You pay only the interest on your mortgage loan
• Minimum payment option: This option requires you to pay a stated minimum payment. This payment may not be enough to cover your interest payments, and so the amount you owe on your mortgage may get larger even if you are making payments every month.
• 15-year payment option with full amortization: This is more similar to a standard ARM with a 15-year term. You make a payment each month equal to the amount it will take to pay off your mortgage in 15 years. The size of that payment is calculated based on the interest rate you are being charged for the month, as you must pay both the interest that accrues under that interest rate and the amount of principle required to keep your loan on tack to be paid off in fifteen years.
• 30 year payment option with full amortization: This is similar to a 15-year option, however under this choice you have 30 years to pay off the loan so your monthly payments are usually smaller.

Risks of A Mortgage Option Loan

Under a mortgage option loan, you may pay a great deal of money in interest over the life of the loan, especially if you elect the minimum payment method and your loan continues to grow larger. It may be difficult or impossible to ever pay off your loan, and eventually your payments may increase dramatically and become impossible to afford. When you are making small payments, you may also become upside down on your home loan or have negative equity. This means that you will end up owing more on your home than the home is worth. This can make it difficult or impossible to refinance or sell.

Who Should Take a Mortgage Option Loan?

Buyers should take a mortgage option loan if they only intend to remain in the home or a short period of time, or if they are confident that they will be able to afford to refinance into a mortgage with a more stable payment structure.

Generally, those who are interested in flipping houses- buying to resell- or who want flexible payments and intend to move or refinance within a few years, should consider a mortgage option loan; however, it is essential to be familiar with all of the risks of this financing method.