Interest Only Mortgage Loans Explained

Interest-only mortgage loans are a source of confusion for many homeowners. If you need the lowest possible payment while minimizing your risk of payment shock, an interest-only mortgage could be your answer. Here are the basics you need to understand about interest-only Adjustable Rate Mortgages (ARM) to make an informed decision and minimize your risk when refinancing.

Adjustable Rate Mortgages 101

What are Adjustable Rate Mortgages and how do they differ from a conventional fixed interest rate loans? Adjustable Rate Mortgages are simply mortgage loans that have a variable interest rate that changes over time. How often your mortgage rate changes depends on the lender and the type of Adjustable Rate Mortgage you’ve chosen; however, every 24 months is a common adjustment period.

What happens when your lender adjusts your mortgage rate? When your mortgage lender adjusts the interest rate they will change your rate to whatever index your loan is tied to plus the lender’s margin. The margin your lender adds is their markup to cover expenses and profit on your loan. When shopping for an Adjustable Rate Mortgage the lender’s margin is an important consideration to make when choosing a loan offer.

What is an index? The index determines your base mortgage rate. Key financial indexes commonly used by mortgage lenders include the Prime Rate, the LIBOR (London InterBank Offered Rate…lenders like this one because they can sell loans tied to the LIBOR to European investors), and the Treasury Index. These interest rates rise and fall based on the supply and demand of credit and other economic factors.

Adjustable Rate Mortgage Features

If you are in the market for an Adjustable Rate Mortgage there are three loan features you need to look at in the offers you consider. These features are the index, margin, and caps. We’ve already discussed index and margin; caps are safety features used to minimize your risk of payment shock when refinancing with an Adjustable Rate Mortgage.

What is payment shock? Imagine waking up one day to a statement from your lender showing that your mortgage rate has gone from 7.5% to 10.5% and your new payment amount will be $700 higher. Fortunately, Adjustable Rate Mortgage loans have built in safety features to protect your from a nightmare like this.

Caps are Adjustable Rate Mortgage safety features that can protect you from payment shock when structured correctly. There are two varieties of caps and you need to make sure your Adjustable Rate Mortgage comes with both types. The first type of cap is called a periodic, or interest rate cap. This cap limits how much your lender can adjust your interest rate up or down during an adjustment period. The second type is payment cap that limits how much your lender can raise or lower your monthly payment during an adjustment period. Both types of caps an have a lifetime cap meaning that the total changes, up or down, are limited over the duration of your loan.

The reason that you need to make sure your Adjustable Rate Mortgage has both types of caps is that loans without properly structured caps can experience negative amortization. What is negative amortization? A mortgage loan that grows over time instead of gradually being paid down is said to be negatively amortized. This happens to Adjustable Rate Mortgages that only have payment caps. When the interest rate goes up and the payment cap doesn’t allow your payment to go up enough to cover all of the interest due in a month the unpaid amount is added to your loan balance. This results in a mortgage that grows overtime. Make sure that your Adjustable Rate Mortgage has both payment and periodic caps.

Interest Only Mortgages Explained

Interest-only mortgages are a special type of Adjustable Rate Mortgage where your payment is based only on the amount of interest due in a given month. Because there is no loan principal included you will have a much lower payment amount with an interest-only mortgage. The problem with interest only mortgages is that they are interest only forever and at the end of the interest only period your lender is going to want the loan principal back.

The interest only period commonly lasts five to seven years. During this time the principal balance remains unchanged as you are only paying the finance charge due each month. At the end of your interest only period the lender will convert your loan to a standard Adjsutable Rate Mortgage adding the loan principal to your payment. When this happens your payment will go up signifiacanlty for two reasons. You are not only paying back the loan balance but your payment is now based on an amortization schedule for the time remaining in your loan. If your intest-only period lasted five years on a 30 year interest only mortgage, your payment will now be based on a 25 year repayment schedule.

Refinancing at the end of your interest-only period can get you a 30 year repayment schedule; however you will have to pay the expenses of taking out a new mortgage.

What About Payment Option Loans?

There is another option for your interest-only mortgage. The so-called “Payment Option” mortgage is the swiss army of all mortgage loans and includes four opitions for your monthly payment. The first payment option is a payment based on a thirty year repayment schedule, the second option is a payment based on a fifteen year repayment schedule, the third is an interest-only payment, and the final option is the often abused minimum payment amount. The problem with the minimum payment amount is that it does not cover all of the interest due in a given month. When you make the optional minimum payment the unapaid interest is added to your loan balance. This is the “negative amortization” phenomemom we discussed earlier.

Homeowners that fall into the trap of making the minimium payment regulary will have their loans recast by their lender when they reach a certain threshold, often 125% of the original loan balance. When this happens the lender will convert their loan to a standard Adjustable Rate Mortgage amortized for the time remaining in the loan term. If your lender recasts your loan because you were abusing the minimum payment you’re almost guaranteed to experice payment shock. Chances are if your were already making the minium payment you will not be able to afford the fully amortized payment…this is a reciepe for disaster that could end in foreclosure.

If you would like to read more advice about refinancing your mortgage without paying too much and minimizing your risk, please register for a copy of the free mortgage refinancing blueprint.