What exactly is an option arm?
Option arms are a fairly recent development in the history of mortgage loan programs.
Simply put, it is an Adjustable Rate Mortgage (ARM) with the "option" to make one of several (usually 4) monthly payments.
Let's get into some more details. The basis for the Option Arm is the adjustable rate mortgage or ARM. An ARM is a loan where the interest rate can change between the time you get the loan and the time the loan is required to be paid back (matures). Some ARMS have a variable rate from the first month, while some are fixed for 10 years. A common loan right now is the 5/1 ARM which is an adjustable rate mortgage that is fixed for the first five years and adjusts every 1 year thereafter. This loan is often paired with an "interest only" feature, but does not include it necessarily.
Now that you know that an ARM can "adjust" it's important to know what it's adjustments are based on. Some ARMS, such as HELOCS (home equity line of credit) are based on the PRIME rate. These are most often 2nd loans. Most 1st loan ARMS are based on an index. An index is a numeric figure, publicly available, that measures economic factors. This figure should roughly rise and fall with the cost of money available to lenders.
So in this way, an adjustable rate mortgage "moves with the market." On top of the index, lender's usually add a margin, which is an arbitrary fixed numeric figure. When added to the index, it yields the "interest rate" of a loan, or note rate (sometimes called "fully-indexed rate" in an option arm, which will be explained below). The margin theoretically constitutes a portion of the lenders profit. Also, the index is not always the lender's actual cost of borrowing money, it is more of a touchstone, a general gauge of how expensive money "is supposed to be" at any given time.
There are numerous indexes. Some are based on US treasuries and other domestic economic indicators, while another very prevalent index is based on the LIBOR (London Interbank Offered Rate), which is the rate at which banks in London offer to lend money to one another. Perhaps the most important things to understand about an index is how it moves historically compared to it's current value.
Here's a site I've linked to in previous answers that has some good charts on indexes.
Now that the basic education of Indexes and Margins is out of the way, let's talk about how they form to create an Option ARM.
An option ARM begins as any other ARM, as a Margin plus an index. On a side note, on many ARMS with a fixed introductory period, the actual rate of the mortgage note will not be exactly equal to the sum of the index and the margin. It will adjust to that sum after the fixed period is over.
Option Arms have historically been adjustable from day one, although some lenders now offer ARMS that are fixed for the first five years.
The most important distinction in an option arm is the difference between RATE and PAYMENT RATE. Unscrupulous lenders have latched on to the option arm as a way to advertise " rates as low as 1%." The truth is, mortgage lenders don't lend money at 1% or anywhere close to it. Those low advertised rates are actually "payment rates."
Here's where it starts to get confusing so lets break it down from the beginning.
The option ARM starts out as an index (4.0 for example) plus a Margin (3.5 for example). This means that your interest rate or "fully indexed rate" would be 7.5.
Now we can build the Option Arm up from this. You will have 4 payment options (usually) and the first 3 of them will be based on this fully indexed rate.
15 year fixed payment, in which the payment is equivalent to that of a 15 year fixed loan at the same rate
30 year fixed payment, in which the payment is equivalent to that of a 30 year fixed loan at the same rate
Interest only payment, in which the payment is equivalent to that of an interest only loan with the same rate.
The fourth option is what all the fuss is about. The fourth option is usually LOWER THAN INTEREST ONLY. That interest doesn't magically disappear. It must be accounted for. Therefore, it is added back onto the balance (or principle) of the loan. This is known as negative amortization.
The amount that is added back onto the principle is exactly equal to the interest only payment minus minimum payment. In equation form
Interest Only Payment - Minimum Payment = amount added back to principle.
Minimum payment rates are used to calculate payments in a couple different ways. The most common way is for the low 1% or 1.5% rate to be used as if it were a 30 year fixed rate. So instead of making a payment at a 7.5% interest rate on a 30 year fixed loan, you could make a payment as if your rate were 1.5%. Just remember that the difference between the interest portion of your payment at 7.5% and the payment at 1.5% will have to be paid back. It's not a free lunch.
Other lenders (especially on newer hybrid products) figure the payment based on the "fully indexed rate" minus a set margin, then calculated as interest only. For instance if an option arm advertises a payment rate of 3% less than the "fully indexed rate," in our example, our payment would then be based on 7.5% minus 3%, then calculated as interest only. So on our 7.5% loan, we'd have the much lower payment associated with 4.5% interest only Again, remember, you have to pay back anything that is less than interest only on the fully indexed rate.
There are many other aspects to option arms relating to payment schedules, misleading advertising, ethical recommendations of their use, their potential as investment tools, etc. But at 5800 words, this answer is long enough. If you need additional clarification on Option Arms (they are a complicated loan when you're first getting acquainted with them), please post a follow up question. Or feel free to email me with burning questions.