Interest Only Mortgage Loans / Payment Option ARMS What are the risks with I-O interest only mortgage payments and payment-option ARMs? Rising monthly payments and payment shock. It is risky to focus only on your ability to make I-O interest only or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap. Negative amortization. If you have a payment-option ARM and make only minimum payments that do not include all of the interest due, the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. And if your loan balance grows to the contract limit, your monthly payments would go up. For example, if your $180,000 loan grew to $225,000 (125% of 180,000), your payments would be recalculated. Refinancing your mortgage. You may be able to avoid payment shock and higher monthly payments by refinancing your mortgage. But no one knows what interest rates will be in 3, 5, or 10 years. And if your loan balance is greater than the value of your home, you may not be able to refinance. Prepayment penalties. Some mortgages, including I-O interest only mortgages and payment-option ARMs, have prepayment penalties. So if you refinance your loan during the prepayment penalty period, you could owe additional fees or a penalty. Most mortgages let you make extra, additional principal payments with your monthly payment. This is not considered "prepayment," and there usually is no penalty for these extra amounts. Falling housing prices. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer. When might an I-O interest only mortgage payment or a payment-option ARM be right for you? Despite the risks of these loans, an I-O interest only mortgage payment or a payment-option ARM might be right for you if the following apply: --you have modest current income but are reasonably certain that your income will go up in the future (for example, if you're finishing your degree or training program), --you have sizable equity in your home and will use the money that would go toward principal payments for other investments, or --you have irregular income (such as commissions or seasonal earnings) and want the flexibility of making I-O or option-ARM minimum payments during low-income periods and larger payments during higher-income periods. When might an I-O mortgage payment or a payment-option ARM not make sense? Interest-only or option-ARM minimum payments may be risky if you won't be able to afford the higher monthly payments in the future. For example, suppose you are in the market for a home and can afford a monthly payment of about $1,100. Depending on the interest rate, with a traditional 30-year, fixed-rate mortgage, you might expect to get a $180,000 mortgage. A lender or broker could offer you an I-O mortgage payment of $1,100 monthly that might enable you to get a $215,000 mortgage--and, therefore, a more expensive house. But keep in mind that your payments could go up because of interest rate increases when the I-O period ends, or when the loan is recalculated. Your $1,100 monthly payment could jump to $1,340 or more. If you cannot reasonably expect to make this larger payment when the time comes, you might want to think about a different type of loan. What are the alternatives to interest only mortgage payments and payment-option ARMs? If you are not sure that an interest only mortgage payment or a payment-option ARM makes sense for you, there are several other alternatives you could consider. ind out if you qualify for a community housing program that offers lower interest rates or reduced fees for first-time homebuyers, making homeownership more affordable. Consider a fixed-rate mortgage or a fully amortizing ARM. Shop around for terms and features that fit your needs and your budget. Take more time to save for a larger down payment, reducing the amount you need to borrow and making your mortgage payments more affordable. Look for a less expensive home. Once you build up equity, you could buy a more expensive home. What are some important target dates in an interest only mortgage or a payment-option ARM? Introductory period. Many option ARMs have a 1-month or 3-month introductory period at the beginning of the loan. During this period, lenders use a lower interest rate to calculate your payments. For some interest only mortgage payment loans, this introductory period lasts 1, 3, or 5 years. Interest rate adjustment period. Most payment-option ARMs have interest rates that adjust monthly after the introductory period. You could find that the interest you owe increases even though your minimum payment stays the same each month, adding to your negative amortization. Typical interest rate adjustment periods for an I-O mortgage are monthly, every 6 months, or once a year. Payment adjustments. Most I-O payment mortgages and payment-option ARMs have payments that adjust once a year. In addition, most of the adjustments on payment-option ARMs are limited by a payment cap, usually 7.5%. Keep in mind that payment caps do not apply when your loan is recalculated at the normal recalculation period. Payment caps also do not apply if your balance grows beyond 110% or 125% of your original mortgage amount. Recalculation period. With a payment-option ARM, your loan will be recalculated, or recast. The recalculation period is usually 5 years, but it can vary depending on the terms of your loan. When your loan is recalculated, the 7.5% payment cap does not apply, so you could see a large change in your monthly payment. After your loan is recalculated, you will still have the option to make a minimum payment. I-O loans are recalculated at the end of the option period (usually 3, 5, or 10 years); after that you will pay back both the principal and interest for the remaining term of the loan. |
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Interest Only Mortgage Loans / Payment Option ARMS What are the risks with I-O interest only mortgage payments and payment-option ARMs? Rising monthly payments and payment shock. It is risky to focus only on your ability to make I-O interest only or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap. Negative amortization. If you have a payment-option ARM and make only minimum payments that do not include all of the interest due, the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. And if your loan balance grows to the contract limit, your monthly payments would go up. For example, if your $180,000 loan grew to $225,000 (125% of 180,000), your payments would be recalculated. Refinancing your mortgage. You may be able to avoid payment shock and higher monthly payments by refinancing your mortgage. But no one knows what interest rates will be in 3, 5, or 10 years. And if your loan balance is greater than the value of your home, you may not be able to refinance. Prepayment penalties. Some mortgages, including I-O interest only mortgages and payment-option ARMs, have prepayment penalties. So if you refinance your loan during the prepayment penalty period, you could owe additional fees or a penalty. Most mortgages let you make extra, additional principal payments with your monthly payment. This is not considered "prepayment," and there usually is no penalty for these extra amounts. Falling housing prices. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer. When might an I-O interest only mortgage payment or a payment-option ARM be right for you? Despite the risks of these loans, an I-O interest only mortgage payment or a payment-option ARM might be right for you if the following apply: --you have modest current income but are reasonably certain that your income will go up in the future (for example, if you're finishing your degree or training program), --you have sizable equity in your home and will use the money that would go toward principal payments for other investments, or --you have irregular income (such as commissions or seasonal earnings) and want the flexibility of making I-O or option-ARM minimum payments during low-income periods and larger payments during higher-income periods. When might an I-O mortgage payment or a payment-option ARM not make sense? Interest-only or option-ARM minimum payments may be risky if you won't be able to afford the higher monthly payments in the future. For example, suppose you are in the market for a home and can afford a monthly payment of about $1,100. Depending on the interest rate, with a traditional 30-year, fixed-rate mortgage, you might expect to get a $180,000 mortgage. A lender or broker could offer you an I-O mortgage payment of $1,100 monthly that might enable you to get a $215,000 mortgage--and, therefore, a more expensive house. But keep in mind that your payments could go up because of interest rate increases when the I-O period ends, or when the loan is recalculated. Your $1,100 monthly payment could jump to $1,340 or more. If you cannot reasonably expect to make this larger payment when the time comes, you might want to think about a different type of loan. What are the alternatives to interest only mortgage payments and payment-option ARMs? If you are not sure that an interest only mortgage payment or a payment-option ARM makes sense for you, there are several other alternatives you could consider. ind out if you qualify for a community housing program that offers lower interest rates or reduced fees for first-time homebuyers, making homeownership more affordable. Consider a fixed-rate mortgage or a fully amortizing ARM. Shop around for terms and features that fit your needs and your budget. Take more time to save for a larger down payment, reducing the amount you need to borrow and making your mortgage payments more affordable. Look for a less expensive home. Once you build up equity, you could buy a more expensive home. What are some important target dates in an interest only mortgage or a payment-option ARM? Introductory period. Many option ARMs have a 1-month or 3-month introductory period at the beginning of the loan. During this period, lenders use a lower interest rate to calculate your payments. For some interest only mortgage payment loans, this introductory period lasts 1, 3, or 5 years. Interest rate adjustment period. Most payment-option ARMs have interest rates that adjust monthly after the introductory period. You could find that the interest you owe increases even though your minimum payment stays the same each month, adding to your negative amortization. Typical interest rate adjustment periods for an I-O mortgage are monthly, every 6 months, or once a year. Payment adjustments. Most I-O payment mortgages and payment-option ARMs have payments that adjust once a year. In addition, most of the adjustments on payment-option ARMs are limited by a payment cap, usually 7.5%. Keep in mind that payment caps do not apply when your loan is recalculated at the normal recalculation period. Payment caps also do not apply if your balance grows beyond 110% or 125% of your original mortgage amount. Recalculation period. With a payment-option ARM, your loan will be recalculated, or recast. The recalculation period is usually 5 years, but it can vary depending on the terms of your loan. When your loan is recalculated, the 7.5% payment cap does not apply, so you could see a large change in your monthly payment. After your loan is recalculated, you will still have the option to make a minimum payment. I-O loans are recalculated at the end of the option period (usually 3, 5, or 10 years); after that you will pay back both the principal and interest for the remaining term of the loan. |
