Option ARM Calculations
This calculator can be used to estimate the monthly payments available through an option adjustable rate mortgage, also known as an option ARM. The calculator needs a total of seven inputs, including:
- The home loan amount, which is the value of the money borrowed
- The starting or introductory rate offered by the lender, sometime referred to as the teaser rate
- A published index rate, which is used to adjust the interest rate of the mortgage over time
- A margin rate, which is the difference between the interest rate charged on the mortgage and the published index rate
- An option ARM allows the borrower to make minimum payments, which means the loan is not fully amortized. The recast cap limits the amount of negative amortization
- The term of the mortgage, with the most common being 15, 20, 25, and 30 years
- The interest rate on prevailing fixed rate mortgages, which allows the user to compare loans
The calculator then provides the user with eight outputs:
- The value of the minimum monthly payment, which is based on the starting rate
- The monthly payment on an interest-only loan, which means the principal of the loan does not decrease over time
- The monthly deferral value, which is the difference between the minimum payment and the interest-only payment
- The fully indexed rate which is the sum of the index plus margin rate
- The recast mortgage value, along with the month the recast occurs, and the fully amortizing monthly payment
- The monthly payment for the fixed rate loan (as a benchmark value)
Option ARM Mechanics
An option ARM is different than a conventional mortgage in that it offers the borrower three options. They can make a minimum payment, an interest-only payment, or a fully amortizing payment (just like a more conventional mortgage). The minimum payment is based on what is termed a starting rate, also known as a teaser rate. This is lower than the interest only payment, and as such, results in negative amortization. This means the outstanding balance on the loan grows during this period.
Our calculator shows the “deferred” value when making a minimum payment. This is the difference between an interest-only payment and the minimum payment. Since the payment is not adequate to repay the interest due on the loan, the outstanding balance grows over time. How much this loan is allowed to grow depends on the recast cap. For example, if the original loan was for 100,000 and the recast cap was 110%, the loan can grow to 110,000. At that point, the borrower will begin making fully amortizing payments.
When making interest-only payment the loan’s principal, or outstanding balance, does not decrease over time. Monthly payments only repay the interest due on the loan. Fully amortizing loans repay both the loan’s principal and interest over the remaining term of the loan. When an option ARM is recast, the borrower must repay the new mortgage amount and interest due over the remaining term. At this point, the payment monthly grows substantially for two reasons. The recast loan is larger than the original loan and there is less time to repay the loan since during some of the term minimum payments were being made to the lender.
Our calculator displays the recast monthly payment along with what the monthly payment would have been with a fixed mortgage. This allows the user to compare these two payments.
Advantages of an Option ARM
If the longer-term recast mortgage payments are higher than a fixed rate mortgage, you might be asking yourself – what are the advantages of an Option ARM? The only advantage of these types of loans is the lower initial payments. However, since the lender is in the business of making money, they will eventually want all the money due as part of the agreement. Borrowers might take out a loan like this if they had a temporary need for access to money. For example, newlyweds might redirect some of the money normally allocated to their mortgage to pay for a wedding. Alternatively, someone just entering the workforce might also select this type of loan if they believe they will be making more money when the loan is recast, thereby making the higher payment more affordable.