An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change).

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.

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. When pricing an Option ARM, never focus on the Start Rate of 1% or 2%, consider only the Fully Indexed Rate (FIR) which is the Margin and the current Index being used (12-MTA, LIBOR, etc.).

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. This gives greater flexibility to how the mortgage is paid. With a fixed-payment loan, if the borrower was unable to meet the fixed payment, they would risk late fees or foreclosure.

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. By making minimum payments over the course of a year, these borrowers are able to defer the majority of the income required to service their mortgage debt to the end of the year, allowing income brought in as a long term capital gain, and taxable at a favorable rate, to be used in making lump sum interest payments. 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.

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.