Legal Definitions - Option ARM

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.