Option Loan Explained

An option loan is an adjustable rate mortgage that allows homeowners to afford substantially larger properties than they otherwise might through traditional instruments. An Option ARM offers exceptionally small payments during the first year, and the rate of the mortgage gets changed every month, unlike a conventional loan.

The ARM payment will be adjusted at the end of every year of the term of your loan. Although Option ARMs are only supposed to expand by 7.5 percent annually, the payment gets recalculated approximately 5 or 10 years into the mortgage.

Thus, it's easy for buyers to get shocked by spiking Option ARM payments several years into the mortgage. In addition, since it's possible to pay so little upfront, homeowners may end up going beyond what's called the maximum negative amortization. If this happens, the minimum payment rates can spike sharply, even before the recasting period expires.

There are ways to improve reduce your risk with an Option ARM. First, understand the various payment scenarios before you lock into a rate. Work with your broker to get a good margin on the Option ARM, since the margin will impact your payments for the life of the loan, which can extend for years. Aim for a low margin, and pay off as much as possible at the very beginning. This way, you can avoid massive interest rate spiking and budget smarter for the future.

Option mortgages present unusual financial risks, but they also allow homeowners to move into larger places faster. If you expect that your income stream will bump up over the next few years, an Option ARM may be a good way to save in the short term (and thus reduce your expenses to get your business off the ground). Many people use Option ARM's to refinance their houses in light of a slowdown at work or sudden debt.

While an ARM can salve the short-term burdens on your pocketbook, be aware that spiking interest rates later on can cause major financial headaches if you're not prepared with money in your reserve fund. In addition to parsing out the maximum rate on your loan, you should also find out how much the lender fees will cost and use all this information to budget at least five years ahead.