The Option ARM has been available since 2002, however they became most popular in 2005. Under an Option ARM, borrowers are typically offered one of four payment options:
- The full payment under an amortized 30-year loan
- The full payment under an amortized 15-year loan
- A full interest-only payment based on the current interest rate
- A minimum payment based on a much lower "teaser" rate.
If you opt to make the minimum payment, the unpaid interest is added to the loan balance. This is called "negative amortization."
Option ARM loans reset their interest rate frequently, often every month, which means payments change every month. In addition, they are recast periodically, usually ever five years. When the loan is recast, the new payments are calculated based on the fully amortized current interest rate and the remaining term. For example, if you have a 30-year-loan, the first recast would determine your payments at the current full rate for the next 25 years.
Many Option ARM loans are not yet due to be recast, however a separate clause has kicked in for many borrowers. When an Option ARM loan reaches 110% or 125% of the original loan value, payments are no longer flexible. You must pay the full rate every month. Unfortunately, the clause may also take effect if the loan balance is 110-125% of the current home value. Many borrowers in declining markets are receiving notices that their payments must now be made in full because of declining values.
Foreclosure and an Option ARM Loan
If you've been notified that you've reached the loan-to-value threshold, it doesn't mean you will be foreclosed automatically. If you can afford to make the fully indexed payments, do so now. You should also try to make additional payments to reduce the principal balance as much as possible.
However, most homeowners are unable to pay the fully indexed rate on the new loan balance. If this is the case for you, you can still avoid foreclosure. Your first step should be to contact your lender to discuss your options.
Unfortunately, an Option ARM doesn't typically qualify as a subprime loan, so it doesn't qualify for the interest-rate freeze program instituted in late 2007. However, you can still find solutions. The possibilities include:
Refinancing or Modifying Your Loan:
If your home is worth less than the loan balance, you may not be able to refinance or sell your home for the full loan amount. If you can increase your down payment, your lender may agree to refinance. They may also be willing to enter you into a loan work-out or modification program to avoid foreclosure.
Selling Your Home:
If you can't refinance, your lender may accept a short sale in order to avoid foreclosure fees. You will have to leave your home, but your credit won't be damaged.
Filing for Forbearance:
You can apply for forbearance if you expect to be able pay your full mortgage, but are currently experiencing hardship due to a job loss or other family emergency. This will temporarily halt your payments and prevent foreclosure while your situation improves.
Filing for Bankruptcy:
Although bankruptcy won't permanently halt foreclosure, it will put a freeze on the process while your filing works through the courts. In addition, bankruptcy could reduce or eliminate other debts that prevent you from making your full loan payment.
Offering a Deed-in-Lieu:
If you are prepared to leave your home, the bank may accept the deed in lieu of foreclosure. This arrangement may damage your credit, but not as much as foreclosure or bankruptcy.
Before you do anything, consult your budget to determine whether you can make the full payments as stated or need help. Next contact your lender before you receive a notice of default. The sooner you act, the more likely you are to receive a positive outcome.