![]() ![]() ![]() Owning a home is part of the American dream. But high home prices may make the dream seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term or (2) make only a specified minimum payment that could be less than the monthly interest on the loan. Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)--or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)--is right for you. Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face
In addition, with payment-option ARMs you could face
Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you're not comfortable with these risks, ask about another loan product. Skip to content What is an I-O mortgage payment? What do you need to ask when shopping for an I-O mortgage payment or a payment-option ARM? What are the risks with I-O mortgage payments and payment-option ARMs? When might an I-O mortgage payment or a payment-option ARM be right for you? When might an I-O mortgage payment or a payment-option ARM not make sense? What are the alternatives to I-O mortgage payments and payment-option ARMs? What are some important target dates in an I-O mortgage or a payment-option ARM? Does the type of loan and loan payment plan make much difference? What should I keep in mind when it comes to an I-O mortgage payment or a payment-option ARM? Comparison of Five $180,000 Mortgage Loans What is an I-O mortgage payment?Traditional mortgages require that each month you pay back some of the money you borrowed (the principal) plus the interest on that money. The principal you owe on your mortgage decreases over the term of the loan. In contrast, an I-O payment plan allows you to pay only the interest for a specified number of years. After that, you must repay both the principal and the interest. Most mortgages that offer an I-O payment plan have adjustable interest rates, which means that the interest rate and monthly payment will change over the term of the loan. The changes may be as often as once a month or as seldom as every 3 to 5 years, depending on the terms of your loan. For example, a 5/1 ARM has a fixed interest rate for the first 5 years; after that, the rate can change once a year (the "1" in 5/1) during the rest of the loan. More information on ARMs is available in the Federal Reserve Board's Consumer Handbook on Adjustable Rate Mortgages. The I-O payment period is typically between 3 and 10 years. After that, your monthly payment will increase--even if interest rates stay the same--because you must pay back the principal as well as the interest. For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then both principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5. What is a payment-option ARM?A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include
Interest rates. The interest rate on a payment-option ARM is typically very low for the first 1 to 3 months (2%, for example). After that, the rate usually rises to a rate closer to that of other mortgage loans. Your monthly payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment, it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, resulting in a highter balance. This is known as negative amortization. Also, as interest rates go up, your payments are likely to go up. Payment changes. Many payment-option ARMs limit, or cap, the amount the monthly minimum payment may increase from year to year. For example, if your loan has a payment cap of 7.5%, your monthly payment won't increase more than 7.5% from one year to the next (for example, from $1,000 to $1,075), even if interest rates rise more than 7.5%. Any interest you don't pay because of the payment cap will be added to the balance of your loan. Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your payments could go up a lot. Ending the option payments. Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated and you would pay back principal and interest based on the remaining term of your loan. It is likely that your payments would go up significantly. What do you need to ask when shopping for an I-O mortgage payment or a payment-option ARM?Use the Mortgage Shopping Worksheet to compare different loan products. Ask lenders or brokers about the details of their loans and about the different loan options they offer. And don't be afraid to make lenders and brokers compete with each other by letting them know you are shopping for the best deal. Look for a mortgage that allows you to buy the house and continue to afford the payments, even if payments go up over time. Mortgage Shopping Worksheet(See also Consumer Handbook on Adjustable Rate Mortgages, Looking for the Best Mortgage, or use the Mortgage Comparison Calculator. |
Example | Mortgage 1 | Mortgage 2 | |
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Name of lender or broker & contact information | ABC Mortgage Co. 800-123-4567 |
___ | ___ |
Mortgage amount | $180,000 | ___ | ___ |
Loan description | Payment-option ARM; 1-month introductory rate; 30-year term | ___ | ___ |
Is this an I-O payment or a payment-option ARM? | Payment-option ARM | ___ | ___ |
If different payment options are available, what are the options? | 1. First year's minimum payment based on initial interest rate 2. Interest-only payment based on rate after adjustment 3. Fully amortizing payment based on 30-year term |
___ | ___ |
What is the full term of the mortgage? | 30 years | ___ | ___ |
How long is the option period? | The loan will be recalculated (recast) every 5 years. Payment options are available every month except (1) when loan is recast every 5 years, (2) when balance is 125% of original loan, or (3) if you fall more than 60 days behind in your payments. | ___ | ___ |
What is the initial interest rate? | 1.6% | ___ | ___ |
For a payment-option ARM, how long does the initial interest rate apply? | 1 month | ___ | ___ |
What will the interest rate be after the initial rate? | 6.4% | ___ | ___ |
How often can the interest rate adjust? | Monthly | ___ | ___ |
What is the periodic interest rate cap? | 2% per year | ___ | ___ |
What is the overall interest rate cap? | 6% lifetime cap (maximum interest rate is 12.4%) | ___ | ___ |
How often will the monthly payments adjust? | Annually | ___ | ___ |
What is the payment cap? | 7.5% per year; does not apply to recalculation every 5th year |
___ | ___ |
Can this loan have negative amortization? | Yes | ___ | ___ |
Is there a limit to how much the balance can grow before the loan will be recalculated? | Up to 125% of original amount borrowed (loan will be recalculated if balance grows to $225,000) | ___ | ___ |
Is there a prepayment penalty if I end this mortgage early by refinancing or selling my home? | Yes | ___ | ___ |
How much is the penalty? | 3% of amount borrowed in 1st year ($5,400), down to 1% of amount borrowed in 3rd year ($1,800); no prepayment penalty after year 3 | ___ | ___ |
What will my monthly payments be for the first year of the loan? | $630 | ___ | ___ |
Does this include taxes and insurance? Homeowner's association fees? | No | ___ | ___ |
What is the most my minimum monthly payment could be after 12 months? | $677 (based on 7.5% cap) |
___ | ___ |
What is the most my minimum monthly payment could be after 24 months? | $728 (based on 7.5% cap) |
___ | ___ |
What is the most my minimum monthly payment could be after 36 months? | $783 (based on 7.5% cap) |
___ | ___ |
What is the most my minimum monthly payment could be after 48 months? | $2,419 (based on recalculation of the loan when balance is $225,000) |
___ | ___ |
What is the most my minimum monthly payment could be after 60 months (5 years)? | $2,419 (based on recalculation of the loan after 4 years) |
___ | ___ |
What would my minimum monthly payment be after 60 months (5 years) if the interest rate stays the same? | $1,308 (based on recalculation of the loan after 5 years) |
___ | ___ |
What are the fees and charges due at closing on this loan? | See good faith estimate | ___ | ___ |
What are the risks with I-O mortgage payments and payment-option ARMs?
When might an I-O mortgage payment or a payment-option ARM be right for you?Despite the risks of these loans, an I-O mortgage payment or a payment-option ARM might be right for you if the following apply:
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 I-O mortgage payments and payment-option ARMs?If you are not sure that an I-O mortgage payment or a payment-option ARM makes sense for you, there are several other alternatives you could consider.
What are some important target dates in an I-O mortgage or a payment-option ARM?
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.
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.
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. What should I keep in mind when it comes to an I-O mortgage payment or a payment-option ARM?
Also, note that
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Traditional fixed-rate mortgage; 30-year term, 6.7% interest rate |
Traditional 5/1 ARM; 30-year term; 6.4% interest rate for first 5 years |
Fixed-rate 5-year interest-only mortgage; 30-year term; 6.9% interest rate |
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%; 7.5% annual payment caps |
|
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Initial monthly payment | $1,161 | $1,126 | $1,035 | $960 | $630 |
Monthly payment in year 6 with no rate change | $1,161 | $1,126 | $1,261 | $1,204 | $1,308 |
Monthly payment in year 6 with 2% rate change | $1,161 | $1,344 | $1,261 | $1,437 | $1,562 |
Balance owed after 5 years | $168,882 | $168,298 | $180,000 | $180,000 | $195,562 |
Home equity in year 5 with $20,000 down payment1 | $31,118 | $31,702 | $20,000 | $20,000 | $4,438 |
1. Assumes home prices and housing values stay constant. Return to table. Glossary
For More InformationLooking for the Best Mortgage--Shop, Compare, Negotiate This information was prepared in consultation with the following agencies and organizations:Center for Responsible Lending |