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Simple English definitions for legal terms
Option ARM
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A quick definition of Option ARM:
An option ARM is a type of mortgage where the borrower can choose how much they want to pay each month. They can pay the full amount, only the interest, or a minimum amount. If they pay the minimum amount, the amount they owe on the mortgage actually goes up instead of down. This type of loan was popular before the 2007-08 financial crisis.
A more thorough explanation:
An option ARM, or adjustable-rate mortgage, is a type of mortgage that gives the borrower different payment options. These options include:
- A payment that covers both the interest and principal amounts, which will reduce the amount owed on the mortgage. This payment can be made over a 15-year or 30-year term.
- A payment that covers only the interest (interest-only), which will not reduce the principal amount.
- A minimum or limited payment that does not cover the interest-only amount. The interest that is not paid is added to the loan's principal balance or total amount on the mortgage.
When the borrower makes the minimum payment, they incur negative amortization, which means that the principal balance of the loan increases. Option ARMs were more popular before the subprime mortgage crisis of 2007-08.
For example, if a borrower has an option ARM and chooses to make the minimum payment, they will not be paying the full amount of interest owed on the loan. This means that the interest that is not paid will be added to the principal balance of the loan, causing it to increase over time.