Question:

What are the dangers of interest only first mortgage loans with adjustable rate?

Answer:

It is true that interest only first mortgage loans with adjustable rates and Option ARM loans with a built-in interest-only option can pose a risk to the inexperienced consumer. If you are not experienced handling your finances, it is recommended that you use professional advice from a finance advisor or consumer credit counseling with a company with proven experience in debt and money management.

Risks of Interest Only First Mortgage Loans with Adjustable Rates

  • Payment shock. Usually I-O home loans are expected to be repaid by the end of the I-O period. When borrowers fail to do that they usually can't afford a rising monthly payment.

    For example, consider a fixed rate mortgage (FRM) loan of $200,000 at 6% for 30 years with 10-year IO period. The interest-only payment is roughly $1000, and the fully amortizing payment for the loan is $1200. In 10 years, if you never made any additional payments towards the principal you will still owe $200,000 and will have to make fully amortizing payments of $1432 monthly for the remaining 20 years of the mortgage term. Of course, you could sell the house.

    With pure interest only adjustable rate mortgage (IO ARM), the increase in the monthly payment will be even more abrupt. Imagine that the interest rate of your adjustable I-O mortgage loan reached 9% in year 12, following some LIBOR index. Your monthly payments (principal and interest) may reach and exceed $1800 when the rate goes up. Monthly payments of Interest-Only ARMs depend on the payment/interest rate adjustment cap and on the adjustment frequency.

  • Home value depreciation. What could have happened to your equity?

    If home values were on the rise, your home may be worth more in value than it was when you bought it. This said, you may no longer pay PMI (private mortgage insurance).

    However, if real estate market was flat or went down, you may be stuck with more mortgage debt than your house is worth and perhaps won't be able to refinance, or sell the house for as much as you need to pay off mortgage debt.

  • Most Interest Only mortgages (ARM or FRM) will have prepayment penalty that will fade away the deeper you go into the mortgage. Usually, monthly payments towards principal and up to 20% yearly of the original loan amount are allowed to prepay with no penalty charges.
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