An interest-only adjustable-rate mortgage (ARM) is a loan where the borrower only pays the interest for a set time. During this interest-only phase, the borrower doesn’t have to pay down any of the principal amount. The duration of this phase can differ from one mortgage to another, ranging from a few months to several years.
Once the interest-only period ends, the mortgage will start to amortize, meaning the borrower will need to pay off the loan by the end of its original term. As a result, monthly payments will significantly increase after the interest-only phase is over. Additionally, interest-only ARMs come with variable interest rates, so the interest payment can change each month based on market conditions.
Understanding about Interest-Only ARM
Interest-only adjustable-rate mortgages (ARMs) can be quite risky. Borrowers not only take on the chance that interest rates might go up, but they also have to deal with a hefty payment once the interest-only phase wraps up. Plus, since the principal balance doesn’t decrease during this period, any change in home equity relies solely on how property values fluctuate. Many borrowers plan to refinance their interest-only ARMs before the interest-only term is over, but a drop in home equity can complicate that process.
Interest-only ARMs faced a lot of backlash after the 2000s real estate bubble burst. These loans were often marketed as a budget-friendly option for people wanting to buy homes that were out of their financial reach during the booming market. With home prices skyrocketing in the early 2000s, lenders persuaded many buyers that they could afford pricier homes through interest-only ARMs, banking on the idea that rising values would allow them to refinance before the interest-only period ended.
However, when home values stopped climbing, many borrowers found themselves stuck with mortgage payments that were far too high. To make matters worse, the collapse of the real estate market led to a recession, causing many homeowners to lose their jobs and making it even harder to keep up with payments.
The Example
You secure a $300,000 interest-only adjustable-rate mortgage (ARM) at a 6% interest rate. For the first 10 years, you only pay interest, which amounts to $1,500 a month. After that initial period, for the next 20 years, you’ll start paying both principal and interest, causing your monthly payment to double. This means that once the interest-only phase wraps up, you’ll have to budget for a significantly higher payment each month, assuming the interest rate stays at 6%.
Conclusion
When interest rates change, some borrowers might lean towards adjustable-rate mortgages (ARMs) to take advantage of lower initial rates. But, interest-only ARMs come with their own set of risks. Once the interest-only phase is over, borrowers face a much larger payment. Plus, since they aren’t paying down the principal at the start, the mortgage balance stays the same. As a result, the equity a borrower builds relies solely on how much the home’s value increases.