What should I keep in mind when it comes to an I-O mortgage payment or a payment-option ARM?
Both types of loans can be flexible and allow you to make lower monthly payments during the first few years of the loan. You can repay some of the principal at any time to help keep future payments lower.
Neither loan may be the right choice if the attraction of an initial smaller monthly payment leads you to take out a larger mortgage than you will be able to afford when the interest-only period ends or when the option payments are recalculated.
Eventually you will have to pay back the principal you borrowed, plus any amounts added to the principal as negative amortization.
You will have lower monthly payments only during the first few years. You will have larger payments later--and you will need to have the income to cover those larger payments.
Also, note that with an adjustable-rate mortgage, interest-only and option-ARM monthly payments can increase, even during the I-O-payment or option period. And, by making I-O or minimum payments, you will not be building equity in your home by paying down the principal on the loan, even though you are making monthly payments. The equity in your home may increase if the market value of your home increases, but the equity could also go down if the market value of your home goes down. With payment-option ARMs, you may be adding to the amount you owe on your mortgage if you pay less than the full interest owed each month.
Comparison of Five $180,000 Mortgage Loans
($200,000 home with a $20,000 down payment)
(1) Traditional fixed-rate mortgage; 30-year term, 6.7% interest rate
Initial monthly payment $1,161
Monthly payment in year 6 with no rate change $1,161
Monthly payment in year 6 with 2% rate change $1,161
Balance owed after 5 years $168,882
Home equity in year 5 with $20,000 down payment (see note 1) $31,118
(2) Traditional 5/1 ARM; 30-year term; 6.4% interest rate for first 5 years
Initial monthly payment $1,126
Monthly payment in year 6 with no rate change $1,126
Monthly payment in year 6 with 2% rate change $1,344
Balance owed after 5 years $168,298
Home equity in year 5 with $20,000 down payment (see note 1) $31,702
(3) Fixed-rate 5-year interest-only mortgage; 30-year term; 6.9% interest rate
Initial monthly payment $1,035
Monthly payment in year 6 with no rate change $1,261
Monthly payment in year 6 with 2% rate change $1,261
Balance owed after 5 years $180,000 $180,000
Home equity in year 5 with $20,000 down payment (see note 1) $20,000
(4) 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
Initial monthly payment $960
Monthly payment in year 6 with no rate change $1,204
Monthly payment in year 6 with 2% rate change $1,437
Balance owed after 5 years $180,000
Home equity in year 5 with $20,000 down payment (see note 1) $20,000
(5) 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%; 7.5% annual payment caps
Initial monthly payment $630
Monthly payment in year 6 with no rate change $1,308
Monthly payment in year 6 with 2% rate change $1,562
Balance owed after 5 years $195,562
Home equity in year 5 with $20,000 down payment (see note 1) $4,438
Note 1: Assumes home prices and housing values stay constant
Glossary
Adjustable-rate mortgage (ARM) -- A mortgage that does not have a fixed interest rate. The rate changes during the life of the loan in line with movements in an index rate, such as the rate for Treasury securities or the Cost of Funds Index.
Amortizing loan -- Monthly payments are large enough to pay the interest and reduce the principal on your mortgage.
Cap, interest rate -- A limit on the amount your interest rate can increase. Interest caps come in two versions: periodic caps, which limit the interest-rate increase from one adjustment period to the next, and overall caps, which limit the interest-rate increase over the life of the loan. By law, virtually all ARMs must have an overall cap.
Cap, payment -- A limit on how much the monthly payment may change, either each time the payment changes or during the life of the mortgage. Payment caps do not limit the amount of interest the lender is earning, so they may lead to negative amortization.
Equity -- The difference between the fair market value of the home and the outstanding mortgage balance.
Good faith estimate -- The Real Estate Settlement Procedures Act (RESPA) requires your mortgage lender to give you a good faith estimate of all your closing costs within 3 business days of submitting your application for a loan, whether you are purchasing or refinancing a home. The actual expenses at closing may be somewhat different from the good faith estimate.
Index -- The index is the measure of interest-rate changes that the lender uses to decide how much the interest rate on an ARM will change over time. No one can be sure when an index rate will go up or down. Some index rates tend to be higher than others, and some change more often. You should ask your lender how the index for any ARM you are considering has changed in recent years, and where the index is reported.
Margin -- The number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.
Negative amortization -- Occurs when the monthly payments do not cover all the interest owed. The interest that is not paid in the monthly payment is added to the loan balance. This means that even after making many payments, you could owe more than you did at the beginning of the loan.
Prepayment penalty -- Extra fees that may be due if you pay off the loan early by refinancing your home. These fees may make it too expensive to get out of the loan. If your loan includes a prepayment penalty, be aware of the penalty you would have to pay. Ask the lender if you can get a loan without a prepayment penalty, and what that loan would cost.
