An Option ARM (adjustable-rate mortgage) is a type of mortgage where the borrower has several possible payment choices. The borrower may pay:
- A payment covering the interest and principal amounts, which will reduce the amount owed on the mortgage.
- This may be made as a 15-year or 30-year term payment.
- A payment that covers only interest (interest-only). This will not reduce principal.
- A minimum or limited payment. This does not cover the interest-only amount, and thus the interest you do not pay is added to the loan’s principal balance or total amount on the mortgage.
When the minimum payment is made, the borrower incurs negative amortization, and the borrower’s principal balance rises. This type of loan made as a subprime mortgage was more popular prior to the subprime mortgage crisis of 2007-08, which developed into the ‘Great Recession’ of 2008. Many people were able to obtain mortgages, or subprime loans, that they ultimately could not afford, largely due to the widespread use of Option ARM’s, which led to a nationwide housing market collapse and subsequent worldwide economic disaster.
[Last updated in July of 2023 by the Wex Definitions Team]