An “option ARM” is a loan where the borrower has the option of making either a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in a given month.

This type of loan is also known and advertised as the “pick a payment” or “pay-option” loan.

When a borrower makes a payment that is less than the interest payment, there is negative amortization, where the unpaid interest is added back onto the principal balance.

Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called “teaser rate”) and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible.

Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. With a fixed-payment loan, if the borrower was unable to meet the fixed payment, they would risk late fees or foreclosure.

The main risk of an Option ARM is “payment shock”, when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance.

The function of the loan that can cause this payment shock is called the “Recast” cap. The recast will happen when the original loan balance reaches 110% to 125% of the original loan balance due to negative amortization of making the minimum payment.

For example: a $200,000 with a 110% recast cap will adjust to a fully indexed, fully amortized payment based on the remaining term of the loan when the negative amortization add to the loan balance reaches $220,000. If it was a 125% recast this will happen when loan balance reaches $250,000.

Historically, option ARM mortgages have been used effectively to minimize income taxes and maximize mortgage interest deductions by high net worth homeowners whose earnings are primarily derived from passive or investment income. High net worth individuals and real estate investors also have a long history of utilizing the negative amortization characteristics of these mortgages to their advantage to avoid taxation entirely on gains in real estate, by refinancing regularly to “take profits” from illiquid residential and commercial real estate equity.[citation needed]

Option ARM mortgages are increasingly available in Hybrid, or temporarily Fixed Rate varieties, from 3 to 10 years, mitigating certain negative amortization characteristics of the popular Adjustable Rate variety. Largely as a result of yield curve inversion, a handful of banks have introduced 30 year fixed rate mortgages with option ARM style minimum payments.