Interest Only Mortgage Loans / Payment Option ARMS

Interest Only Mortgage Loans / Payment Option ARMS

Does the type of loan and loan payment plan make much difference?

Yes. . . for both the growth of your investment in your home and the amount of your monthly payments during the term of the loan.

Equity growth. During the first few years of a traditional mortgage loan, most of your monthly payment goes to interest. The rest goes toward the principal, so that you start to build equity in your home through payments. Thus, the amount you owe declines and you own more of your home. If you make interest-only payments, you are not building equity. And if you make only the minimum payments with a payment-option ARM, you may actually be adding to the amount you owe (and decreasing your equity) because unpaid interest is added to the loan's principal. For example, if you were to buy a $200,000 home with a 10% downpayment and a $180,000 mortgage, here's what your home equity might look like after 5 years (with no changes in property value) with different kinds of loans:

LOAN TYPE

Traditional fixed-rate mortgage; 30-year term; 6.7% interest

Traditional 5/1 ARM; 30-year term; 6.4% for first 5 years

5/1 interest-only ARM; 30-year term; 5 years of I-O payments, then 25 years of principal and interest payments; 6.4% interest rate for first 5 years

Payment-option ARM; 30-year term; 5 years of minimum payments, then recast for remaining term; starting interest rate of 1.6% for 1 month, then 6.4%; assume no rate increases

Payment-option ARM; 30-year term; 5 years of minimum payments allowed, then recast for remaining term; starting interest rate of 1.6%, then 6.4%; 7.5% annual payment cap; assume rate increases 2% per year up to 12.4%. This loan will reach the 125% balance limit in month 49 and will be recast as an amortizing loan at the beginning of year 5.

These numbers are only examples; your balance will depend on the type of loan, the interest rate, and how often the interest rate changes.

Monthly payments. At the beginning of a mortgage, I-O and option-ARM payments are likely to be lower than traditional mortgage payments. But when the I-O payment period ends or when your payment-option ARM loan is recast, your payments could change a lot. If you have a 30-year mortgage with a 5-year I-O payment, you will have only 25 years, instead of 30, to repay the principal, and your monthly payment will rise. With a 30-year payment-option ARM, at the end of the first 5-year period, your loan is recalculated based on a 25-year term. In some cases your monthly payment could double or even triple.

The table below shows an example of the differences over 5 years in the monthly payment of 5 different mortgage loans, all with the original loan amount of $180,000.

Traditional fixed-rate mortgage--The monthly payment stays at $1,161 over the life of the loan.

5/1 traditional ARM--The monthly payment stays at $1,126 for 5 years but then changes with the interest rate. In the example, the monthly payment would be $1,344 if interest rates rose 2% in year 6. A 5/1 ARM is an ARM in which the rate is fixed for the first 5 years and then may adjust every year during the remainder of the loan term.

Fixed-rate 5-year interest-only mortgage--The monthly payment stays at $1,035 for the first 5 years and then increases to $1,261 in year 6 as you begin to pay down the principal.

5/1 interest-only ARM--The monthly payment stays at $960 for 5 years but increases to $1,204 in year 6. The payment rises because interest rates are rising and because you did not pay down the principal during the first 5 years. If interest rates rose 2%, the monthly payment in year 6 would be $1,437.

Payment-option ARM with minimum monthly payment--The minimum monthly payment starts at $630, but this amount does not cover all of the interest ($957). The payment rises 7.5% each year (payments are $677 in year 2, $728 in year 3, $783 in year 4, and $842 in year 5). The loan is recast at the beginning of year 6. If interest rates stay the same, the monthly payment would be $1,308. If interest rates go up 2%, the monthly payment would be $1,562.

If you choose the minimum-payment option ARM to lower your monthly payment to $630 because you cannot afford higher monthly payments, will you be able to afford the monthly payments in the future? Before taking an I-O mortgage or a payment-option ARM, think about not only how you will make the initial payments but also whether you can make the payments in the years ahead.

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