What Are the Pros and Cons of an Interest-Only ARM Mortgage?

Would-be homeowners looking to buy a house may opt for an interest-only adjustable-rate mortgage (ARM), which lets them make payments on just the mortgage's interest for the first few years. As with a typical ARM, the interest rate varies with the market, which means payments usually change throughout the life of the loan. This may be seen as a benefit by some, because payments are reduced when the market rate is lowered, but it also means payments increase when the market rate climbs. Interest-only ARMs feature low initial payments, allowing homebuyers to purchase a home they could not afford with a standard fixed-rate loan. On the other hand, payments usually jump substantially when the interest-only period ends and payments on the principal are added in; rising interest rates can also add to that increase.

An interest-only ARM mortgage is often attractive to homebuyers who want a home with payments they cannot afford when using a fixed-rate loan. This is because payments during the first few years of an interest-only ARM mortgage are lower to reflect that only the interest is being paid. Once the specified interest-only period ends, the loan is fully amortized, adding in the principal and greatly increasing the payment. This option usually appeals to borrowers who do not earn much money when buying the home but are expecting to have a higher income within a few years. It can also be beneficial to those who plan to refinance to a fixed rate mortgage once the interest-only period is up, until which time they can enjoy low payments.

Some homebuyers benefit from the varying rate on an interest-only ARM mortgage, because it decreases in some markets. A low interest rate is beneficial on a regular ARM mortgage, but when it is an interest-only ARM, borrowers can enjoy particular savings. Thus, this type of mortgage is appealing to homebuyers when the rate is low.

On the other hand, opting for an interest-only ARM mortgage is risky, because the rates can fluctuate substantially. A loan that seems beneficial one month may become quite expensive the next, so borrowers need to be prepared for a higher payment. Additionally, once the interest-only period ends and the loan is amortized, the payment will usually jump dramatically to pay down the principal. While the extreme increase in the house payment can be challenging on its own, it is especially scary when the interest rate also increases greatly. When this occurs, people may lose their home to the bank unless they are financially prepared for the sudden payment increase in their interest-only ARM mortgage.