If you are considering refinancing your mortgage with an Interest Only or Option Adjustable Rate Mortgage, there are a number of pitfalls you need to know about. While it’s true that interest loans and option mortgages are much riskier than traditional mortgages, when used correctly these loans could save you thousands of dollars. There are several tips to help you avoid the pitfalls of interest only loans.
What are the Differences Between Interest Only and Option Loans?
Interest only mortgages are as their name implies, loans with payments based only on the amount of interest due that month. Option loans offer greater flexibility; however, they are also more prone to abuse by homeowners who do not understand the risk. Option loans are also called “payment option” loans because the homeowner has the choice of making several different payments each month. If you refinance your mortgage with a payment option loan you’ll have the choice of making a payment based on a 30-year repayment schedule, a 15-year repayment schedule, an interest only payment, and the ultra-risky “minimum payment.”
The problem with the minimum payment option is that it does not cover all of the interest due and the unpaid amount is simply tacked on to the outstanding balance of your loan. This results in a phenomenon known as “negative amortization,” or simply put a loan that grows over time.
What are the Pitfalls of Interest Only Loans?
Negative amortization is one pitfall; however, the single greatest pitfall you could face with an interest only loan, or any Adjustable Rate Mortgage for that matter, is payment shock. This happens when you wake up one day and find that the lender has either adjusted your interest rate or recast the loan and you can no longer afford your payment. Payment shock happens for several different reasons.
Many homeowners find that after abusing Option Adjustable Rate Mortgages with the minimum payment, their loan balance reaches 110% to 125% of their home’s value and the lender automatically recasts their loan. Recasting simply means the lender is executing their right to convert the loan to a fully-amortizing Adjustable Rate Mortgage. If you’ve been keeping your budget afloat by paying the minimum amount on an Option Adjustable Rate Mortgage, you will undoubtedly experience payment shock first hand.
Recasting isn’t limited to option loans; homeowners with interest only loans could face recasting if their caps are not structured properly. Caps are the built in safety features that protect homeowners from rising interest rates and skyrocketing payment amounts. There are two varieties of caps that you need to be aware of: periodic caps and payment caps. Periodic caps limit the amount your interest rate can go up during any adjustment period or in the case of a lifetime periodic cap, over the entire duration of your loan. Similarly, payment caps limit how much your payment can change during any one adjustment or over the lifetime of the loan.
When refinancing with any type of Adjustable Rate Mortgage you need to make sure that your loan has both periodic and payment caps. Loans that only have payment caps are prone to negative amortization and ultimately recasting when the cap prevents the payment from going up enough to cover all of the interest due in a given month. When this happens the unpaid interest is added to the outstanding balance just as it is with the minimum option payment.
Other pitfalls of interest only mortgages include overpaying for lender margin and fees. The margin is the amount your lender tacks on to your interest rate after each adjustment for a profit. Many homeowners think that when the lender adjusts their mortgage rate it changes to whatever index their loan is tied to; however, lenders always markup the index with their margin. The margin is set by the lender so you’ll want to carefully compare margins when shopping for your interest only mortgage.
You can learn more pitfalls of interest only loans, including strategies to avoid paying too much with my free refinancing toolkit. Register today by clicking the DVD image at the top of this page; the toolkit is yours free with no obligation.