If you are considering refinancing your mortgage with an interest-only Adjustable Rate Mortgage, there are several things you need to know in order to make an informed decision before signing on the dotted line. Adjustable Rate Mortgages come with the risk of payment shock when your lender adjusts the interest rate. Payment shock means waking up one day to mortgage payment you can no longer afford; here are several tips to help you decide if interest-only mortgage refinancing is right for you.
What Are Interest-Only Adjustable Rate Mortgages?
Interest-only mortgages are a type of adjustable rate mortgage where your monthly payment amount is based only on the amount of interest due that month and does not include any of the actual loan balance. Many homeowners purchase their homes with interest-only mortgages because they need the lowest possible payment amount; what many don’t understand is that interest-only mortgages do not remain interest-only forever.
At some point your lender is going to want their money back and when this happens your loan is converted to a standard Adjustable Rate Mortgage amortized for the time remaining in your loan contract.
What Every Homeowner Needs to Know About Mortgage Amortization
Amortization is a word that gets kicked around a lot but what does it mean when it comes to your mortgage loan? First of all, amortization describes the process of repaying your loan. Mortgage loans are front loaded with interest, meaning that you pay the majority of interest on the loan up-front. Your amortization schedule outlines how much of your payment is applied to interest and how much goes to the loan balance over time. You can see your amortization schedule using a basic mortgage calculator and you’ll notice that over the years the dollar amount applied to interest goes down while the portion paid back increases. What does this mean for interest-only mortgage holders?
During the interest-only period of your loan there is no amortization whatsoever. Your lender pockets the entire amount you pay each month. This interest-only period lasts for a period of time specified in your loan contract, often five to seven years. At the end of the interest-period your loan is converted to a standard Adjustable Rate Mortgage at the prevailing interest rate plus the lender’s margin.
Your amortization schedule starts when the lender converts your loan based on the time remaining in your contract. Suppose your interest-only period lasts five years on a thirty-year Adjustable Rate Mortgage. At the end of the five year interest-only period, your payments are based on a twenty-five year amortization schedule meaning they will be much higher than if you had refinanced with a standard thirty year adjustable.
Once you understand how your interest-only mortgage works you can budget for the future when your payments go up and reduce your risk of payment shock. There are other factors you need to consider when deciding if an interest-only mortgage is right for you, mainly your tolerance for financial risk. Mortgage interest rates are nearly impossible to predict and economic uncertainty coupled with your lender’s generous margin has the potential for you to wind up with double digit mortgage rates.
You can learn more about your mortgage refinancing options, including costly pitfalls to avoid with my free refinancing video tutorial. Register today with no obligation by clicking the DVD image at the top of this page.
My name is Rob Regehr and I’m a personal finance writer with a chip on my shoulder for banks and brokers that take advantage of my friends and neighbors.
