A pay option ARM is an adjustable-rate mortgage that allows the buyer to choose to an extent what her payment will be. She can choose a more regular interest and principal payment, an interest-only option or a fixed lower payment. The pay option ARM usually initially has a low interest rate for the first few months and then rises to a normal rate after that.
Pay option ARMs are particularly good as short-term loans for speculators, builders or those who intend to fix up properties in order to sell them. This sort of mortgage allows extra money to be used to fix up the property or time to sell it without having to pay a large mortgage payment every month.
Because ARMs tend to be easier to qualify for, they are also good for people who couldn't qualify under normal circumstances because of income or credit issues. They can have low payments that give them time to change their situations, and then they can simply refinance to more stable products later.
A pay option ARM can also be a good option for someone whose income fluctuates, letting her pay a minimum when her income is low and more when it increases.
The pay option refers only to how you pay and has no effect on the interest charged, so it is possible, even likely, that if a buyer chooses the fixed option and the interest exceeds the payment, the loan will "negatively amortize." In other words, the difference will be added to the principal, and the loan amount will actually grow. With the interest-only option, the buyer is not paying down the principal at all, so she is not actually buying the property; she isn't building equity, so it's sort of like paying rent.
As with any ARM, the buyer must stay on top of the situation and use it to her advantage. If she doesn't, she can find herself in a situation where she owes vastly more than what the property is worth. Many buyers have found themselves in the situation of being unable to refinance because they owe more than what their properties are worth.
The Really Ugly
Regardless of the option, the adjustable-rate mortgage is inherently risky. Even if a buyer does everything right, it is possible that the Federal Reserve could raise interest rates. Depending on a lot of factors, even a small change could make a huge difference in the interest rate. If the interest rate changes, the mortgage could suddenly far surpass the property's worth, bankrupting even the most prepared buyer.
There are great advantages in the pay option ARM, but there are also great risks. If you decide to use this option, don't do it lightly. Seriously consider how to tailor the ARM to your specific needs. The bottom line is that if you truly can't afford the property, an ARM is not the solution. There are far better stratagies that can help you reach your goal.