Interest-only loans are generally adjustable rate mortgages allowing you to pay only the interest part of your loan payments for a specific time. Unlike traditional mortgage loans, you may forego paying the principal for a set period - usually between five and ten years. Monthly payments during the interest-only term are much lower than traditional mortgages. When the interest-only term expires, the interest rate adjusts and you must make payments toward both principal and interest for the rest of the loan. As a result, monthly payments increase.
Option ARMs give you the ability to decide how much to pay from one month to the next, for a specific time. You may choose from payment options including:
- Interest-only payment
- Minimum payment not including all interest due
- Full principal and interest payment based on the remaining scheduled term of the loan or on a 15-year or 30-year term.
Like interest-only loans, there is a significant payment increase when the payment option term expires. When the interest rate adjusts you must make payments toward both principal and interest. Your monthly payments increases.
If you need a $300,000 loan for 30 years you could expect something like the below examples. Keep in mind the rates used in the examples below are only assumptions.
Traditional Fixed-Rate Mortgage: At an interest rate of 6.0%, monthly payments would be $1,799 for the life of the loan. Monthly payments include both repayment of principal and interest.
Interest-Only Mortgage: Assume a fixed interest rate of 5% for the first 5 years of the loan, the length of the interest-only term. At an initial interest rate of 5%, the monthly payments would be $1,375. At year 6, assuming the interest rate adjusts to 7.5%, the payments rise to $2,227 - an increase of $852.
Option ARM: Assume the initial indexed interest rate is 6.3% (the starting or "teaser" interest rate may be much lower). At first, you may pay as little as $1,035 by deferring $557 in interest per month. This interest gets added onto the loan balance. Or you could pay as much as $1,870 by paying both principal and interest. If you make only the minimum payment, monthly payments, including both interest and principal, may increase to as much as $2,612 once the option term ends and the full interest and principal due must be repaid.
Benefits of interest-only loans and option ARMs
Interest-only loans and option ARMs can be effective wealth management tools. If you have the knowledge and ability to make wise financial decisions you may benefit by investing the savings generated from a lower initial monthly payments. During the interest-only term, your entire monthly payment may be tax-deductible.
You may benefit from lower initial monthly payments if:
- Your income is commission-based or seasonal
- You earn a salary and receive infrequent bonuses
- You expect your income to significantly increase in a few years
- You're planning to refinance your loan before the end of the interest-only term or payment option term.
- You know you'll be in the home for only a few years
- You are not concerned with building equity.
Risks of interest-only loans and option ARMs
- You can overextend yourself. Since initial monthly payments are lower, you may be tempted to buy a more expensive home than you can afford. Without a significant increase in income, repayment could become difficult or impossible.
- You may not build equity. Equity is the difference between home value and outstanding loan balance. If you make interest payments and do not make payments toward principal, you build no equity.
- If you have an option ARM and choose to make monthly payments that do not cover the full amount of interest and other fees accrued, the extra amount gets added to the principal balance due. You may end up owing more money than the original loan amount. This result is known as negative amortization.
- Selling your home before the interest-only term or payment option term expires may result in owing more than the original loan amount. This will happen if your home value decreased during that period.
- You may not be able to refinance. Many borrowers who pick an interest-only loan or option ARM assume that the value of the homes will increase. With this mindset, borrowers plan to make lower monthly payments in the short term, and then refinance. If the home value remains the same or decreases, you may not be able to refinance as planned - the outstanding loan amount may be greater than the home's value.