Is This Interest-Only ARM a No-Brainer?

February 18, 2003, Revised November 18, 2006, Reviewed February 13, 2011

"I plan to refinance my 7.25% loan into a 4% adjustable rate mortgage (ARM) that is interest-only for 10 years. I don’t plan to hold this mortgage for more than 8 years. Unless I’m missing something, the decision seems like a no-brainer."

You are missing something. The fact that this ARM is interest-only for 10 years does not mean that the 4% rate holds for 10 years. Probably it holds for only 6 months. Then, it can spike, or maybe not, depending on what happens to market interest rates during the period, and on other features of this loan that you don’t know about. This risk makes your decision anything but a "no-brainer".

Interest-Only Period Versus Initial Rate Period

Your letter is one of many I have received recently that ask about 10-year interest-only ARMs. It took me awhile to realize what was going on. Some smart operators are taking advantage of the recent popularity of interest-only loans to confuse borrowers into believing that the tooth fairy has arrived. Only the tooth fairy is offering mortgages at 4% for 10 years.

These smart alecks don’t lie, but they allow prospective borrowers to lie to themselves. Borrowers are left to assume that the interest-only period is the same as the initial rate period. It is not. The interest-only period is the period during which you are allowed to pay interest only. The initial rate period is the period for which the quoted interest rate holds.

To illustrate the difference, assume the initial rate period is 6 months and the interest only period 10 years. On a $100,000 loan at 4%, the interest-only payment is $333. If the rate after 6 months goes to 6%, the interest-only payment would jump to $500. It is higher because the interest rate is higher, but it remains interest-only.

How fast and how far a rate increase might go depends partly on what happens in the market. There is no way to know that. But it also depends on the contractual features of this ARM, which you can know but haven’t yet bothered to find out.

Information Needed For Determining the "Worst Case"

To find out at least how bad it could be – the "worst case" – you need to know the following:

* How long the initial rate holds -- assume 6 months.

* How often the rate adjusts after the initial rate period ends -- assume every 3 months.

* The maximum rate change -- assume 2% on the first adjustment, 1% on subsequent adjustments.

* The highest rate allowed by the contract -- assume 10%.

Using the assumptions I made above, under a worst case the rate would rise from 4% to 10% in 18 months. On a $100,000 loan, the initial payment of $333.34 would jump to $500 in month 7, to $583.34 in month 10, to $666.67 in month 13, to $750 in month 16, and to $833.34 in month 19.

An Overlooked Hazard in Interest-Only Loans

This example points up a hazard in an interest-only ARM that loan officers are not likely to raise. The payment increase resulting from an interest rate increase is significantly larger than on an ARM that requires a fully-amortizing payment. A fully amortizing payment includes principal and will pay off the balance at term. The payment on a fully-amortizing ARM would begin at $477.42 and rise to $868.85 in month 19. This is an 82% increase, compared to a 150% increase in the interest-only payment.

This does not mean that the ARM under discussion is a bad instrument that should be avoided. The point is that ARMs should be selected with eyes wide open to their risk. It is the difference between selecting an ARM and being sold an ARM.

Unfortunately, loan providers seldom volunteer the information needed to assess the risk – you have to ask for it. There is a checklist you can use for this purpose – see Information Needed to Evaluate an ARM. If the loan officer can’t or won’t fill it in, run.

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