Interest Only ARM

How do Interest-Only Mortgages Work?

Mortgages are “interest only” when the borrower's monthly mortgage payment consists of interest only. The mortgage can obviously not be interest only forever: the "interest only period" is defined in the note and generally ranges from 5 to 10 years. After the interest only period is over, the mortgage begins amortizing over the remaining term of the mortgage (and this is where "payment shock" comes into play). Lender's in some states even advertised their own brands of intest only loans such as the California Interest Only Loan, the Arizona Interest Only Loan and the New York Interest Only loan.

Borrowers have the option to pay principal, but they rarely do. This means that the mortgage is NOT PAID DOWN AT ALL during the interest only period. The result is that when the interest only period is over, the borrower has a much higher amortizing payment because the entire loan must now amortize over a shorter period (the original loan term minus the interest only period).

In addition, these loans almost always have an adjustable rate. In today's market, the variable rate works against borrowers by increasing the rate applicable to the mortgage. In certain types of loans the payment is fixed at a specific interest rate for the interest only period while the actual rate can rise or fall. If the rate rises (which is what has happened recently) the borrower isn't actually paying ALL THE INTEREST and the unpaid interest is being added to the principal balance of the mortgage (Negative Amortization). If the rate falls, the excess amount of the payment is used to decrease the principal amount.

When times were good and house prices were appreciating rapidly (such as the California housing market from the mid 90's until about 2005), homeowner's frequently used their increased equity to refinance out of interest only mortgages before the end of the interest only term. Now, these loans are a ticking time bomb as borrowers (even borrowers with good credit) cannot refinance out of these loans.

Reasons why a Borrower cannot refinance out of an Interest Only Loan:

1. In many cases, lenders are simply not offering this type of loan anymore.
2. Lenders have imposed more stringent underwriting requirements
3. Even if the lender is still offering an interest only product, the borrower may not qualify because they've tightened up the minimum requirements (credit score, fico, down payment, etc.) necessary to qualify for the loan.
4. In today's market, the actual price of the house may have decreased. This throws off the required parameters necessary to get the loan. For instance, the lender may require at least 20% down to qualify for this loan. If the borrower has not paid down the principal and the house has gone down in value, the borrower's equity has been decreased by the lower value of the house BUT THE ORIGINAL LOAN AMOUNT has stayed the same.

For example:

2005: Borrower buys House for $500,000 with $100,000 down (80/20) with interest only loan.
2008: Borrower wants to refinance but house is only worth $450,000. Lender only lends to 80% requiring 20% down. Borrower can only get a loan for $360,000 (.8 x $450,000) but needs to pay off the full $400,000 original loan resulting in a $40,000 gap. Borrower is effectively prevented from refinancing out of their interest only loan.

So, you are probably asking: "why would anyone want an Interest-Only Mortgage?"

Interest-only mortgages are ideal for borrowers who need the lower initial payment, but are fully prepared to deal with future increase.

The classic example is a doctor just setting up his own practice. In the early years, he'll need money to grow his business. After 5 or 10 years, his income is likely to be large enough to handle the increase in payment.

Another common example is for borrowers with fluctuating incomes. They may only make the minimum payment when their income is low, but can make additional payments when they receive larger income. This is common among authors, photographers, and other people who work on a pay for hire basis.

So what do you do if you're trapped in an Interest Only Loan?

Start paying the maximum amount you can into the mortgage? (maybe or maybe not): The best way for your average homeowner to accrue wealth is to pay down mortgage debt and increase equity in their home. Unless you are able to get a higher rate of return by investing that excess money, you should be applying it toward your mortgage. (Realistically, will you really be investing the excess cash flow? or will you be spending it!)

It's worth noting that some people used Interest Only mortgages for great short term success during the boom:

Housing Capital Gain: interest-only mortgages allowed borrowers to leverage their income, buy a larger house than they could afford with a traditional 30 year fixed loan, and make the profit based on a more expensive asset. The Interest only aspect decreases the initial payment, which let borrowers qualify for a larger loan amount. The more expensive the house, given the same percentage increase, the larger the capital gain. 

This is why California buyers (when there was strong price appreciation) traditionally gravitated to IOs (or the even riskier loan, the Payment Option ARM). California borrowers both the most expensive houses they could qualify for and often got the largest capital gain this way. From a conventional standpoint: if you don’t need an Interest Only to qualify for your desired house, then don't use it to save money.