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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.
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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.
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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.
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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.
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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.
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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 Balance After 5 years
||Equity After 5 years
|Traditional fixed-rate mortgage; 30-year term; 6.7% interest rate
($20,000 down payment plus $11,118 paid on mortgage)
|Traditional 5/1 ARM; 30-year term; 6.4% for first 5 years
($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
($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
($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.
($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.