What it means
In an ordinary repayment mortgage, each payment covers interest and a slice of the original loan. In this type of mortgage, the first years require interest only, so the balance stays exactly where it began, usually for five, seven or ten years.
The adjustable-rate part means the rate is not fixed for the whole term. It is often fixed for an opening period, then resets at regular intervals to a benchmark rate plus a margin, within limits called caps that restrict how much it can rise at each reset and over the life of the loan.
The attraction is a low initial payment. Borrowers with variable income, such as those who are paid large bonuses, or investors who expect to sell soon, may like the extra cash flow in the early years.
The risk is payment shock. When the interest-only period ends, the loan balance must be repaid over the remaining years, which are fewer than the original term, so the payment can rise sharply even if the interest rate has not changed.
Another risk is that the borrower has built no equity through repayments, so the home value must rise for equity to grow. If prices fall, the borrower can end up owing more than the property is worth, which makes refinancing or selling difficult.
Lenders usually apply stricter checks to these loans, and often test whether the borrower can afford the higher payments that will apply after the interest-only period. A borrower should always ask for a payment schedule showing what happens at every reset date.
In practice
Real-world examples.
Example
A self-employed consultant with lumpy income takes an interest-only ARM so that her monthly cost is low in quiet months. She plans to make extra payments after large invoices are paid.
Example
A property investor buys a rental flat with an interest-only ARM and plans to sell within five years. The low payments help the rent cover the cost, but he must be sure he can sell before the payments change.
Example
A young professional expecting rapid pay rises uses an interest-only ARM to afford a larger home. His financial planner shows him the higher payments after the reset and advises him to save the difference each month.
Formula
Calculation
Interest-only payment = Loan balance x Annual interest rate / 12
Payment after interest-only period = Loan x r / [1 - (1 + r)^-n], where r is the new monthly rate and n is the months remaining
A borrower takes a $400,000 interest-only ARM at 6% with a 10-year interest-only period and a 30-year term. The payment is 400,000 x 0.06 / 12 = $2,000 a month, and the balance stays at $400,000. After 10 years, assume the rate resets to 7%, and the loan must be repaid over the remaining 240 months. The new payment is about $3,101 a month, an increase of 3,101 / 2,000 = about 55%, even though the rate rose only one point.Case study
Seen in the real world.
Lakeside Residential is an illustrative, fictional developer whose buyers often chose interest-only ARMs to afford new apartments. One buyer, Priya, borrowed $400,000 at 6% and paid $2,000 a month for seven years.
At the end of year seven, the rate reset to 7.5% and the loan began to amortise over the remaining 23 years, pushing her payment to about $3,045. Property values in the area had been flat, so she had no equity to borrow against and could not easily refinance.
Priya managed by cutting costs and renting a room, but she had no cushion. The fictional case's illustrative lesson is that borrowers should plan for the higher payment from day one, and treat the low early payment as a temporary benefit and not a permanent saving.
Watch out
Common mistakes.
- Assuming the low initial payment will last, when it rises sharply once the interest-only period ends.
- Counting on rising house prices to build equity, when prices can stay flat or fall and the loan balance has not been reduced.
- Ignoring the rate caps and reset dates in the loan terms, which control how much and how fast the payment can change.
Questions
People also ask.
Do I repay the loan during the interest-only period?
You are not required to, but most lenders let you make extra payments, and doing so reduces the balance and the later payment.
What happens when the interest-only period ends?
The loan is recalculated so that the balance is repaid over the remaining term, and the payment usually rises noticeably.
Who is this type of mortgage suitable for?
It may suit disciplined borrowers with irregular income or a clear plan to sell or refinance, but it carries more risk than a standard repayment mortgage.
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