- Option ARM
- An adjustable-rate mortgage that lets you choose each month among several payments, typically a minimum payment, an interest-only payment and a fully amortizing payment. The minimum is often below the interest owed, so choosing it grows the balance. These loans were widely associated with borrower losses and are now rare.
- Negative amortization
- A rising loan balance that occurs when payments do not cover the interest due; the unpaid interest is added to principal. You then pay interest on the added interest. With an option ARM, paying only the minimum causes it, so you can owe more than you originally borrowed, as the year-one balance result shows.
- Deferred interest
- The part of each month’s interest that the minimum payment does not cover, calculated here as the interest-only payment minus the minimum payment. It is not forgiven; it is added to the loan balance. Deferred interest is the monthly engine of negative amortization.
- Minimum payment
- The lowest payment the loan allows, sized from a low minimum payment rate rather than the note rate. It looks affordable, but when it is below the interest due, the shortfall becomes deferred interest. The minimum payment typically rises at set intervals and resets when the loan recasts.
- Interest-only payment
- A payment equal to one month’s interest on the current balance at the note rate. It keeps the balance from growing but repays no principal. Comparing it with the minimum payment shows how much interest is being deferred each month; comparing it with the fully amortizing payment shows the principal you are not repaying.
- Fully amortizing payment
- The payment that would repay the loan in full over its remaining term at the note rate, covering all interest plus principal. It is the payment a comparable fixed-rate schedule would require. At recast the loan is forced to this payment, often from a much higher balance than at the start.
- Note rate
- The interest rate at which interest actually accrues on the loan each month, as stated in the promissory note. On an option ARM it adjusts with an index plus a margin after any introductory period. It is distinct from the minimum payment rate, which only sizes the minimum payment and does not reduce the interest you owe.
- Recast trigger
- A loan term that forces the payment to be reset to the fully amortizing amount, either on a fixed schedule or when the balance reaches a set percentage of the original loan amount (the negative amortization cap). Because the new payment covers a larger balance over fewer years, the jump, often called payment shock, can be steep.
- Adjustable-rate mortgage (ARM)
- A mortgage whose interest rate changes periodically based on a market index plus a fixed margin, usually within caps on each adjustment and over the loan’s life. An option ARM is one type, distinguished by its choice of payments. Standard ARMs amortize normally; the option to pay less than the interest due is what sets option ARMs apart.
