Interest-Only Mortgage Payments and Payment-Option ARMs
Owning a home is part of the American dream. But high home prices may make the dream seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term or (2) make only a specified minimum payment that could be less than the monthly interest on the loan.
Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)--or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)--is right for you. Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face
"payment shock." Your payments may go up a lot--as much as double or triple--after the interest-only period or when the payments adjust.
In addition, with payment-option ARMs you could face
negative amortization. Your payments may not cover all of the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.
Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you're not comfortable with these risks, ask about another loan product. Skip to content
What is an I-O mortgage payment?
Traditional mortgages require that each month you pay back some of the money you borrowed (the principal) plus the interest on that money. The principal you owe on your mortgage decreases over the term of the loan. In contrast, an I-O payment plan allows you to pay only the interest for a specified number of years. After that, you must repay both the principal and the interest.
Most mortgages that offer an I-O payment plan have adjustable interest rates, which means that the interest rate and monthly payment will change over the term of the loan. The changes may be as often as once a month or as seldom as every 3 to 5 years, depending on the terms of your loan. For example, a 5/1 ARM has a fixed interest rate for the first 5 years; after that, the rate can change once a year (the "1" in 5/1) during the rest of the loan. More information on ARMs is available in the Federal Reserve Board's Consumer Handbook on Adjustable Rate Mortgages.
The I-O payment period is typically between 3 and 10 years. After that, your monthly payment will increase--even if interest rates stay the same--because you must pay back the principal as well as the interest. For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then both principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5.
What is a payment-option ARM?
A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include
a traditional payment of principal and interest (which reduces the amount you owe on your mortgage). These payments may be based on a set loan term, such as a 15-, 30-, or 40-year payment schedule.
an interest-only payment (which does not change the amount you owe on your mortgage).
a minimum (or limited) payment (which may be less than the amount of interest due that month and may not pay down any principal). If you choose this option, the amount of any interest you do not pay will be added to the principal of the loan, increasing the amount you owe and increasing the interest you will pay.
Interest rates. The interest rate on a payment-option ARM is typically very low for the first 1 to 3 months (2%, for example). After that, the rate usually rises to a rate closer to that of other mortgage loans. Your monthly payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment, it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, resulting in a highter balance. This is known as negative amortization. Also, as interest rates go up, your payments are likely to go up.
Payment changes. Many payment-option ARMs limit, or cap, the amount the monthly minimum payment may increase from year to year. For example, if your loan has a payment cap of 7.5%, your monthly payment won't increase more than 7.5% from one year to the next (for example, from $1,000 to $1,075), even if interest rates rise more than 7.5%. Any interest you don't pay because of the payment cap will be added to the balance of your loan.
Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your payments could go up a lot.
Ending the option payments. Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated and you would pay back principal and interest based on the remaining term of your loan. It is likely that your payments would go up significantly.
What do you need to ask when shopping for an I-O mortgage payment or a payment-option ARM?
Use the Mortgage Shopping Worksheet to compare different loan products. Ask lenders or brokers about the details of their loans and about the different loan options they offer. And don't be afraid to make lenders and brokers compete with each other by letting them know you are shopping for the best deal. Look for a mortgage that allows you to buy the house and continue to afford the payments, even if payments go up over time.
Mortgage Shopping Worksheet
(See the Consumer Handbook
on Adjustable Rate Mortgages to help you compare other ARM features and
Looking for the Best Mortgage
to help you compare other loan features.)
Printer version of worksheet (27 KB PDF)
|Example||Mortgage 1||Mortgage 2|
|Name of lender or broker & contact information||ABC Mortgage Co.
|Loan description||Payment-option ARM; 1-month introductory rate; 30-year term||___||___|
|Is this an I-O payment or a payment-option ARM?||Payment-option ARM||___||___|
|If different payment options are available, what are the options?||1. First year's minimum payment based on initial interest rate
2. Interest-only payment based on rate after adjustment
3. Fully amortizing payment based on 30-year term
|What is the full term of the mortgage?||30 years||___||___|
|How long is the option period?||The loan will be recalculated (recast) every 5 years. Payment options are available every month except (1) when loan is recast every 5 years, (2) when balance is 125% of original loan, or (3) if you fall more than 60 days behind in your payments.||___||___|
|What is the initial interest rate?||1.6%||___||___|
|For a payment-option ARM, how long does the initial interest rate apply?||1 month||___||___|
|What will the interest rate be after the initial rate?||6.4%||___||___|
|How often can the interest rate adjust?||Monthly||___||___|
|What is the periodic interest rate cap?||2% per year||___||___|
|What is the overall interest rate cap?||6% lifetime cap (maximum interest rate is 12.4%)||___||___|
|How often will the monthly payments adjust?||Annually||___||___|
|What is the payment cap?||7.5% per year;
does not apply to recalculation every 5th year
|Can this loan have negative amortization?||Yes||___||___|
|Is there a limit to how much the balance can grow before the loan will be recalculated?||Up to 125% of original amount borrowed (loan will be recalculated if balance grows to $225,000)||___||___|
|Is there a prepayment penalty if I end this mortgage early by refinancing or selling my home?||Yes||___||___|
|How much is the penalty?||3% of amount borrowed in 1st year ($5,400), down to 1% of amount borrowed in 3rd year ($1,800); no prepayment penalty after year 3||___||___|
|What will my monthly payments be for the first year of the loan?||$630||___||___|
|Does this include taxes and insurance? Homeowner's association fees?||No||___||___|
|What is the most my minimum monthly payment could be after 12 months?||$677
(based on 7.5% cap)
|What is the most my minimum monthly payment could be after 24 months?||$728
(based on 7.5% cap)
|What is the most my minimum monthly payment could be after 36 months?||$783
(based on 7.5% cap)
|What is the most my minimum monthly payment could be after 48 months?||$2,491
(based on recalculation of the loan when balance is $225,000)
|What is the most my minimum monthly payment could be after 60 months (5 years)?||$2,491
(based on recalculation of the loan after 4 years)
|What would my minimum monthly payment be after 60 months (5 years) if the interest rate stays the same?||$1,308
(based on recalculation of the loan after 5 years)
|What are the fees and charges due at closing on this loan?||See good faith estimate||___||___|
What are the risks with I-O mortgage payments and payment-option ARMs?
Rising monthly payments and payment shock. It is risky to focus only on your ability to make I-O or minimum payments, because you will eventually have to pay all of the interest and some of the principal each month. When that happens, the payment could increase a lot, leading to payment shock. In the worksheet example, the monthly minimum payment on the option-ARM payment rises from $630 in the first year to $1,308 in year 6, assuming the interest rate stays at 6.4%. The monthly payment could go up to $2,419 if interest rates reach the overall interest rate cap.
Negative amortization. If you have a payment-option ARM and make only minimum payments that do not include all of the interest due, the unpaid interest is added to the principal on your mortgage, and you will owe more than you originally borrowed. And if your loan balance grows to the contract limit, your monthly payments would go up. For example, if your $180,000 loan grew to $225,000 (125% of 180,000), your payments would be recalculated.
Refinancing your mortgage. You may be able to avoid payment shock and higher monthly payments by refinancing your mortgage. But no one knows what interest rates will be in 3, 5, or 10 years. And if your loan balance is greater than the value of your home, you may not be able to refinance.
Prepayment penalties. Some mortgages, including I-O mortgages and payment-option ARMs, have prepayment penalties. So if you refinance your loan during the prepayment penalty period, you could owe additional fees or a penalty. In the Mortgage Shopping Worksheet example, the penalty is 3% in the first year, 2% in the second year, and 1% in the third year. In this case, you could owe $3,600 if you refinance in year 2. Most mortgages let you make extra, additional principal payments with your monthly payment. This is not considered "prepayment," and there usually is no penalty for these extra amounts.
Falling housing prices. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Even if home prices stay the same, if you have negative amortization, you may owe more on your mortgage than you could get from selling your home. Also, you may find it difficult to refinance. And if you decide to sell, you may owe the lender more than the amount you receive from the buyer.
When might an I-O mortgage payment or a payment-option ARM be right for you?
Despite the risks of these loans, an I-O mortgage payment or a payment-option ARM might be right for you if the following apply:
you have modest current income but are reasonably certain that your income will go up in the future (for example, if you're finishing your degree or training program),
you have sizable equity in your home and will use the money that would go toward principal payments for other investments, or
you have irregular income (such as commissions or seasonal earnings) and want the flexibility of making I-O or option-ARM minimum payments during low-income periods and larger payments during higher-income periods.
When might an I-O mortgage payment or a payment-option ARM not make sense?
Interest-only or option-ARM minimum payments may be risky if you won't be able to afford the higher monthly payments in the future. For example, suppose you are in the market for a home and can afford a monthly payment of about $1,100. Depending on the interest rate, with a traditional 30-year, fixed-rate mortgage, you might expect to get a $180,000 mortgage. A lender or broker could offer you an I-O mortgage payment of $1,100 monthly that might enable you to get a $215,000 mortgage--and, therefore, a more expensive house. But keep in mind that your payments could go up because of interest rate increases when the I-O period ends, or when the loan is recalculated. Your $1,100 monthly payment could jump to $1,340 or more. If you cannot reasonably expect to make this larger payment when the time comes, you might want to think about a different type of loan.
What are the alternatives to I-O mortgage payments and payment-option ARMs?
If you are not sure that an I-O mortgage payment or a payment-option ARM makes sense for you, there are several other alternatives you could consider.
Find out if you qualify for a community housing program that offers lower interest rates or reduced fees for first-time homebuyers, making homeownership more affordable.
Consider a fixed-rate mortgage or a fully amortizing ARM. Shop around for terms and features that fit your needs and your budget.
Take more time to save for a larger down payment, reducing the amount you need to borrow and making your mortgage payments more affordable.
Look for a less expensive home. Once you build up equity, you could buy a more expensive home.
What are some important target dates in an I-O mortgage or a payment-option ARM?
Introductory period. Many option ARMs have a 1-month or 3-month introductory period at the beginning of the loan. During this period, lenders use a lower interest rate to calculate your payments. For some I-O mortgage payment loans, this introductory period lasts 1, 3, or 5 years.
Interest rate adjustment period. Most payment-option ARMs have interest rates that adjust monthly after the introductory period. You could find that the interest you owe increases even though your minimum payment stays the same each month, adding to your negative amortization. Typical interest rate adjustment periods for an I-O mortgage are monthly, every 6 months, or once a year.
Payment adjustments. Most I-O payment mortgages and payment-option ARMs have payments that adjust once a year. In addition, most of the adjustments on payment-option ARMs are limited by a payment cap, usually 7.5%. Keep in mind that payment caps do not apply when your loan is recalculated at the normal recalculation period. Payment caps also do not apply if your balance grows beyond 110% or 125% of your original mortgage amount.
Recalculation period. With a payment-option ARM, your loan will be recalculated, or recast. The recalculation period is usually 5 years, but it can vary depending on the terms of your loan. When your loan is recalculated, the 7.5% payment cap does not apply, so you could see a large change in your monthly payment. After your loan is recalculated, you will still have the option to make a minimum payment. I-O loans are recalculated at the end of the option period (usually 3, 5, or 10 years); after that you will pay back both the principal and interest for the remaining term of the loan.
Does the type of loan and loan payment plan make much difference?
Yes. . . for both the growth of your investment in your home and the amount of your monthly payments during the term of the loan.
Equity growth. During the first few years of a traditional mortgage loan, most of your monthly payment goes to interest. The rest goes toward the principal, so that you start to build equity in your home through payments. Thus, the amount you owe declines and you own more of your home. If you make interest-only payments, you are not building equity. And if you make only the minimum payments with a payment-option ARM, you may actually be adding to the amount you owe (and decreasing your equity) because unpaid interest is added to the loan's principal. For example, if you were to buy a $200,000 home with a 10% downpayment and a $180,000 mortgage, here's what your home equity might look like after 5 years (with no changes in property value) with different kinds of loans.
|Loan Type||Loan Balance After 5 years||Equity After 5 years|
|Traditional fixed-rate mortgage; 30-year term; 6.7% interest rate||$168,882||$31,118
($20,000 down payment plus $11,118 paid on mortgage)
|Traditional 5/1 ARM; 30-year term; 6.4% for first 5 years||$168,298||$31,702
($20,000 down payment plus $11,702 paid on mortgage)
|5/1 interest-only ARM; 30-year term; 5 years of I-O payments, then 25 years of principal and interest payments; 6.4% interest rate for first 5 years||$180,000||$20,000
($20,000 down payment)
|Payment-option ARM; 30-year term; 5 years of minimum payments, then recast for remaining term; starting interest rate of 1.6% for 1 month, then 6.4%; assume no rate increases||$195,562||$4,438
($20,000 down payment minus $15,562 negative equity)
|Payment-option ARM; 30-year term; 5 years of minimum payments allowed, then recast for remaining term; starting interest rate of 1.6%, then 6.4%; 7.5% annual payment cap; assume rate increases 2% per year up to 12.4%. This loan will reach the 125% balance limit in month 49 and will be recast as an amortizing loan at the beginning of year 5.||$223,432||-$22,432
($20,000 down payment minus $42,432 in negative equity)
These numbers are only examples; your balance will depend on the type of loan, the interest rate, and how often the interest rate changes.
Monthly payments. At the beginning of a mortgage, I-O and option-ARM payments are likely to be lower than traditional mortgage payments. But when the I-O payment period ends or when your payment-option ARM loan is recast, your payments could change a lot. If you have a 30-year mortgage with a 5-year I-O payment, you will have only 25 years, instead of 30, to repay the principal, and your monthly payment will rise. With a 30-year payment-option ARM, at the end of the first 5-year period, your loan is recalculated based on a 25-year term. In some cases your monthly payment could double or even triple.
The table below shows an example of the differences over 5 years in the monthly payment of 5 different mortgage loans, all with the original loan amount of $180,000.
Traditional fixed-rate mortgage--The monthly payment stays at $1,161 over the life of the loan.
5/1 traditional ARM--The monthly payment stays at $1,126 for 5 years but then changes with the interest rate. In the example, the monthly payment would be $1,344 if interest rates rose 2% in year 6. A 5/1 ARM is an ARM in which the rate is fixed for the first 5 years and then may adjust every year during the remainder of the loan term.
Fixed-rate 5-year interest-only mortgage--The monthly payment stays at $1,035 for the first 5 years and then increases to $1,261 in year 6 as you begin to pay down the principal.
5/1 interest-only ARM--The monthly payment stays at $960 for 5 years but increases to $1,204 in year 6. The payment rises because interest rates are rising and because you did not pay down the principal during the first 5 years. If interest rates rose 2%, the monthly payment in year 6 would be $1,437.
Payment-option ARM with minimum monthly payment--The minimum monthly payment starts at $630, but this amount does not cover all of the interest ($957). The payment rises 7.5% each year (payments are $677 in year 2, $728 in year 3, $783 in year 4, and $842 in year 5). The loan is recast at the beginning of year 6. If interest rates stay the same, the monthly payment would be $1,308. If interest rates go up 2%, the monthly payment would be $1,562.
If you choose the minimum-payment option ARM to lower your monthly payment to $630 because you cannot afford higher monthly payments, will you be able to afford the monthly payments in the future? Before taking an I-O mortgage or a payment-option ARM, think about not only how you will make the initial payments but also whether you can make the payments in the years ahead.
What should I keep in mind when it comes to an I-O mortgage payment or a payment-option ARM?
Both types of loans can be flexible and allow you to make lower monthly payments during the first few years of the loan. You can repay some of the principal at any time to help keep future payments lower.
Neither loan may be the right choice if the attraction of an initial smaller monthly payment leads you to take out a larger mortgage than you will be able to afford when the interest-only period ends or when the option payments are recalculated.
Eventually you will have to pay back the principal you borrowed, plus any amounts added to the principal as negative amortization.
You will have lower monthly payments only during the first few years. You will have larger payments later--and you will need to have the income to cover those larger payments.
Also, note that
with an adjustable-rate mortgage, interest-only and option-ARM monthly payments can increase, even during the I-O-payment or option period.
by making I-O or minimum payments, you will not be building equity in your home by paying down the principal on the loan, even though you are making monthly payments. The equity in your home may increase if the market value of your home increases, but the equity could also go down if the market value of your home goes down.
with payment-option ARMs, you may be adding to the amount you owe on your mortgage if you pay less than the full interest owed each month.
Traditional fixed-rate mortgage;
30-year term, 6.7% interest rate
Traditional 5/1 ARM;
30-year term; 6.4% interest rate for first 5 years
5-year interest-only mortgage;
30-year term; 6.9% interest rate
5/1 interest-only ARM;
5 years of I-O payments then 25 years of principal and interest payments; 6.4% interest rate for first 5 years
5 years of minimum payments then recast for remaining term; starting interest rate of 1.6% for 1 month, then 6.4%; 7.5% annual payment caps
|Initial monthly payment||$1,161||$1,126||$1,035||$960||$630|
|Monthly payment in year 6 with no rate change||$1,161||$1,126||$1,261||$1,204||$1,308|
|Monthly payment in year 6 with 2% rate change||$1,161||$1,344||$1,261||$1,437||$1,562|
|Balance owed after 5 years||$168,882||$168,298||$180,000||$180,000||$195,562|
|Home equity in year 5 with $20,000 down payment1||$31,118||$31,702||$20,000||$20,000||$4,438|
1. Assumes home prices and housing values stay constant. Return to table.
- Adjustable-rate mortgage (ARM)
- A mortgage that does not have a fixed interest rate. The rate changes during the life of the loan in line with movements in an index rate, such as the rate for Treasury securities or the Cost of Funds Index.
- Amortizing loan
- Monthly payments are large enough to pay the interest and reduce the principal on your mortgage.
- Cap, interest rate
- A limit on the amount your interest rate can increase. Interest caps come in two versions:
periodic caps, which limit the interest-rate increase from one adjustment period to the next, and
overall caps, which limit the interest-rate increase over the life of the loan. By law, virtually all ARMs must have an overall cap.
- Cap, payment
- A limit on how much the monthly payment may change, either each time the payment changes or during the life of the mortgage. Payment caps do not limit the amount of interest the lender is earning, so they may lead to negative amortization.
- The difference between the fair market value of the home and the outstanding mortgage balance.
- Good faith estimate
- The Real Estate Settlement Procedures Act (RESPA) requires your mortgage lender to give you a good faith estimate of all your closing costs within 3 business days of submitting your application for a loan, whether you are purchasing or refinancing a home. The actual expenses at closing may be somewhat different from the good faith estimate.
- The index is the measure of interest-rate changes that the lender uses to decide how much the interest rate on an ARM will change over time. No one can be sure when an index rate will go up or down. Some index rates tend to be higher than others, and some change more often. You should ask your lender how the index for any ARM you are considering has changed in recent years, and where the index is reported.
- The price paid for borrowing money, usually given in percentages and as an annual rate.
- The number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.
- Negative amortization
- Occurs when the monthly payments do not cover all the interest owed. The interest that is not paid in the monthly payment is added to the loan balance. This means that even after making many payments, you could owe more than you did at the beginning of the loan.
- Prepayment penalty
- Extra fees that may be due if you pay off the loan early by refinancing your home. These fees may make it too expensive to get out of the loan. If your loan includes a prepayment penalty, be aware of the penalty you would have to pay. Ask the lender if you can get a loan without a prepayment penalty, and what that loan would cost.
- The amount of money borrowed or the amount still owed on a loan.
For More Information
This information was prepared in consultation with the following agencies and organizations:
Center for Responsible Lending
Consumer Federation of America
Consumer Mortgage Coalition
Credit Union National Association
Federal Deposit Insurance Corporation
Federal Reserve Bank of New York
Federal Trade Commission
Financial Services Roundtable
National Consumers League
Office of the Comptroller of the Currency
Office of Thrift Supervision
Rutgers Cooperative Extension
University of Illinois Cooperative Extension