Interest-Only ARM

What Is an Interest-Only ARM?

An interest-only adjustable-rate mortgage (ARM) is a type of mortgage loan in which the borrower is only required to pay the interest portion owed each month for a certain period of time. During the interest-only period, only interest accrued each period must be paid, and a borrower is not required to pay down any principal owed. The length of the interest-only period varies from mortgage to mortgage but can last anywhere from a few months to several years.

After the interest-only period, the mortgage must amortize so that the mortgage will be paid off by the end of its original term. This means that monthly payments must increase substantially after the initial interest-only period lapses. Interest-only ARMs also have floating interest rates, meaning that the interest payment owed each month changes in market conditions.

Understanding Interest-Only ARMs

Interest-only adjustable rate mortgages can be risky financial products. Not only do borrowers assume the risk that interest rates will rise, but they will also face a ballooning payment once the interest-only period ends. Additionally, because the mortgage principal balance is not reduced during the interest-only period, the rate at which home equity increases, or decreases, is entirely dependent upon home-price appreciation. Most borrowers intend to refinance an interest-only ARM before the interest-only period ends, but a reduction in home equity can make this difficult.

Interest-only adjustable rate mortgages, or ARMs, came under a great deal of criticism in the years following the bursting of the 2000s real estate bubble. Because such mortgages can be tantalizingly inexpensive to service during the interest-only period, they were marketed as a way for prospective homeowners to buy homes they couldn’t afford. Because real estate prices were appreciating so quickly in the early years of the 2000s, mortgage lenders convinced many homeowners that they could buy an expensive home using an interest-only ARM, because continued price appreciation would enable those borrowers to refinance their loan before the interest-only period ends.

Of course, when homes stopped appreciating in value, many borrowers were stuck with mortgage payments well beyond what they could afford. What’s worse, as the bursting of the real estate bubble pulled the U.S. economy into recession, it also caused many homeowners to lose their jobs, making repayment even more difficult.

Hybrid ARMs

A 5/1 hybrid adjustable-rate mortgage (5/1 ARM) begins with an initial five-year fixed-interest rate period, followed by a rate that adjusts on an annual basis. The "5" in the term refers to the number of years with a fixed rate, and the "1" refers to how often the rate adjusts after that (once per year). As such, monthly payments can go up — sometimes dramatically — after five years.

There are 3/1, 7/1, and 10/1 ARMs, as well. These loans offer an introductory fixed rate for three, seven, or 10 years respectively, after which they adjust annually. Other ARM structures exist, such as the 5/5 and 5/6 ARMs, which also feature a five-year introductory period followed by a rate adjustment every five years or every six months, respectively. Notably, 15/15 ARMs adjust once after 15 years and then remain fixed for the remainder of the loan. Less common are 2/28 and 3/27 ARMs.

Example of Interest-Only ARM

Let’s say that you take out a $100,000 interest-only, adjustable-rate mortgage at 5%, with an interest rate-only period of 10 years, followed by 20 more years of payments of both interest and principle. Assuming that interest rates remain at 5%, you would only have to pay $417 per month in interest for the first ten years. When the interest-only period ends, the amount owed each month would double, as you would then have to begin making principal payments as well as interest payments.