Option One Mortgage Loans—How They Work
In a traditional adjustable rate mortgage (ARM), you have only one payment option—the full amount of the principal and interest required to pay the balance of the loan off in the established time period (amortization). Option one mortgage loans differ in that they offer three separate payment options: minimum payment, interest only, and full amortization. Your monthly payment will differ depending on which payment option you choose.
Minimum Payment
The lowest payment option is generally the minimum required payment. The minimum payment is calculated by adding the monthly principal amount to a starting rate, usually between one and two percent. For example, the minimum monthly payment on a $100,000 mortgage with a starting rate of 1.25% would be $333.25.
Interest-Only Payment
An interest-only payment is calculated by determining the amount of interest you are responsible for each month based on your actual interest rate (index plus margin). For example, the interest-only payment on the same $100,000 mortgage with a 3% index and 2% margin would be $416.67.
Full-Amortization Payment
A full-amortization payment is calculated in the same way a monthly payment is calculated on a traditional ARM. A full-amortization payment on the $100,000 mortgage with a 5% interest rate would be $536.82 (based on a 30-year term).
While lower payments can be appealing, borrowers should understand that they are still responsible for the same amount they would pay monthly with the full-amortization option. If a borrower only pays the minimum payment on the mortgage given in the above examples, they would still be responsible for the $203.57 difference between that payment and the full amortization amount. The unpaid portion would then be added to the principal and charged interest.
The minimum monthly payment will increase by 7.5% each year. After a period established by the lender, usually five years, the loan will convert to a traditional ARM, and payment options will no longer be available. The borrower will then be responsible for the full-amortization payment, including any additional unpaid interest amounts from the optional payment period.
Though an option one mortgage loan can be beneficial for borrowers who would initially struggle to pay the fully amortized monthly payments, it's not a good mortgage for borrowers who want to earn equity on their home.
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