Interest-Only ARMs

An interest only ARM is a type of adjustable-rate mortgage loan that is offered with a lower initial rate that balloons up after a specified period. In a typical interest only ARM arrangement, a borrower can choose a multi-year fixed-rate option. After the option expires, the ARM adjusts in relationship to an underlying interest-rate index. Interest only ARMs are generally offered to sub-prime borrowers or individuals with low down payments as a way to hold down their loan interest costs.

Common Interest Only ARMs

The design most common with an interest only arm is either a 2/28 or 3/27 loans. 2/28 interest only ARMs have a 2-year low fixed-rate option that changes into an ARM in year 3. A 3/27 is similar with a longer fixed-rate period before it changes to an ARM. Both of these types are usually set at 7 percent although they can be lower depending on the lender or the borrower. 2/28 and 3/27 are 30-year mortgage loans as indicated by the numbers.

Interest Only ARM Example

A borrower who takes out a 7 percent 2/28 interest only ARM of $400,000 would make payments of around $2,300 for the first 24 months of the interest only ARM. After 24 months, the loan adjusts and the payments go from $2,300 to a little more than $3,300 or higher, depending on the underlying LIBOR index and any additional margin charged by the lender. The LIBOR stands for the London Interbank Offered Rate and is an index that is most commonly used by bank and lenders to set lending rates for loans.

Issues Facing Interest Only ARM Borrowers

Changes in mortgage loan financing do not permit borrowers of a 2/28 or 3/27 interest only ARM to refinance after the initial period into another 2/28 or 3/27 loan. The borrower will have to rely on whatever resources they have to pay the additional $1,000 per month that the loan adjusts. This translates in an additional $12,000 per year that the borrower has to pay on the loan. The loan will be subject to further adjustments as interest rates rise and changes are made to the LIBOR index.

Interest only ARMs are a way for borrowers who may otherwise be unable to secure a mortgage to obtain the financing necessary to buy a home. These loans should be monitored carefully when interest rates begin to rise after the initial period of 2 or 3 years is over in order to control costs for the borrower. A borrower who has a 2/28 or 3/27 that conforms to Fannie Mae or Freddie Mac standards for 30-year mortgages may consider refinancing or modifying the loan in order to lower their monthly payments and maintain their home.