Explainer: Interest-Only Mortgages and Payment-Option ARMs

Education & Training

Buying a home involves a whole series of complex terms and procedures that can be confusing for first time buyers. The American real estate system features a variety of specialized practices to transfer properties safely and protect landowners, lenders, buyers, and sellers alike. However, the terms and procedures used are not easy to navigate without guidance. With this Explainer series, we here at JustRentToOwn.com hope to unlock some of the specialized language associated with real estate that can cause hangups during your rent to own experience.

Mortgage loans come in all shapes and sizes. Literal dozens of different kinds of mortgages exist in the world, and knowing which is best for your personal situation can be confusing. As lenders rely on borrowers for their business, asking the person tasked with underwriting your loan can answer some questions, but you can never be too sure that you’re getting the full picture. More importantly, there are several types of loan that may seem to have great benefits but actually spell trouble for the wrong kind of borrower. Today, I want to discuss two of those types: interest-only payment plan and payment-option ARMs.

What are interest-only payment plans?
To help get buyers in the door of their new homes, some lenders offer loans that require lower payments for a specific period of time early in the loan. These payments only cover the interest on the payment and don’t pay down the principal, ie. the actual cost of the house, at first. After a determined period of time, the borrower’s payments change to cover both interest and the principal monthly, boosting the amount owed on each payment.

What are the benefits?
These types of loans allow people who can anticipate an increase in their income within a period of time to get into their homes with lower initial payments. If there is a strong likelihood that you’ll be making more money over the course of the next several years, or you can anticipate additional income from a spouse going to work or some other source, these payment plans act as a jump off point to get you started.

How about Payment-Option?
Payment-option ARM is an adjustable rate mortgage that give you the opportunity to choose how much you pay monthly, based on a couple payment options. You can pay the traditional amount (interest and principal), pay only the interest for the month, or go with a minimum payment which may be less than interest. This type of loan is beneficial for people whose income may fluctuate, either month to month or seasonally. Originally, they were designed for wealthy folks who receive a large portion of their yearly compensation in bonuses, but they can also be highly beneficial for self employed people who can anticipate their revenue flow and have a solid grasp on their finances. When planned well, borrowers can pay down the principle at a rate comparable to traditional loans and grow equity.

Because the rate is adjustable, your interest rate will likely fluctuate with current interest rates, though there is a payment cap of 7.5 percent to ensure your payments don’t fluctuate too wildly from month to month. In most cases, your payment rate will be recalculated every five years based on the remaining term of your loan–and this is where your loan may be “recast” with a higher-than-the-payment-cap increase.

Flexibility is nice. What’s the catch?

Payment shock.
Both loans can lead to what’s known as payment shock–where the amount you owe for your payment goes up a whole lot very suddenly. For interest-only payment loans, when the interest-only period ends, the borrower is responsible for paying the interest and principal, like a traditional loan, which can boost the amount owed monthly several hundred dollars. For payment-option ARMs, the payment can change drastically when the loan is reconsidered every five years or so depending on interest rates and the amount paid down on the principle.

Negative amortization. 
When your monthly payments are lower than the amount of interest you accrue, the added interest gets tacked onto what you owe–meaning you can actually owe more on the principal of the home than what you bought it for. This is known as negative amortization, which we have discussed previously. In effect, it adds to the principal you owe and puts you in a negative equity situation. Not good!

Both loans are designed to benefit specific types of borrowers. Understanding your finances and making sure that you are financially prepared–and disciplined–enough for these financial tools is key to not finding yourself in the hole.

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