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What is an option or payment-option ARM?

An option or payment-option ARM is an adjustable rate mortgage with several possible payment choices.

Some of the payment choices do not cover the full amount needed to pay down the loan. The payment “options” usually include:

  • Paying an amount that covers both your principal and interest. This is the only way you can reduce the amount you owe on your mortgage loan with each payment.
  • Paying an amount that covers only your interest. Interest-only payments do not pay down your principal, or the amount you borrowed.
  • Paying a minimum (or limited) amount that does not even cover the interest. The interest you do not pay will be added to your principal loan balance. This increases the amount of debt you owe.

Your mortgage payment includes at least two parts – principal and interest. Principal is what you borrowed from the lender. Interest is what the lender charges you for the use of the money you borrowed. Your payment may also include the cost of taxes and insurance if you have an escrow account. If you don’t repay the principal, you are not making any progress in paying back the debt. If you are not paying all the interest, it will get added to what you owe.

If you have a payment-option ARM and you’re regularly skipping your principal or full interest payments to make ends meet, you may be heading for trouble.

Try to avoid paying interest on interest.

Certain loans have payment options that let you pay only a portion of the amount of interest you owe each month. If you only pay some of the interest, the amount that you do not pay may get added to your principal balance. Then you end up paying not only interest on the money you borrowed, but interest on the interest you are being charged for the money you borrowed. This dramatically increases the amount of debt you have and the cost of the loan. To keep your debt from growing, try to pay down all of the interest and at least some of the principal you owe each month.