What it is:
An interest-only mortgage in which the borrower only pays the interest on the for a set period.is a
How it works (Example):
In general, an interest-only prime rate, but sometimes , the one-year constant-maturity Treasury, or other benchmarks) plus an additional spread (which is also called the , and its size is often based on the borrower's credit score). The plus the spread equals the interest rate on the ; it is called the fully indexed rate. Some ARMs a discounted rate, also called a teaser rate, during the first or so.means the borrower only pays the interest on the for a set period. The interest rate can be fixed or variable. The interest rate on an interest-only adjustable-rate , for example, corresponds to a specific (often the
To understand how interest-onlyaffect a borrower's payment, let's assume that a bank offers a $100,000 to a potential borrower at 8%. The monthly payment would be $733.77 -- of which $666.67 is interest and $67.10 of which is of the original $100,000 amount. But in an interest-only , the payment is only the interest portion: $666.67. This reduces the borrower's payment, but it leaves the outstanding (and accruing more interest).
If the interest rate is variable and the interest rate goes to, say, 9%, the interest-only payment goes to $750. In many cases, adjustable-ratehave caps--limits on how high and sometimes how low the interest rate can go, and how much they can move in any one , month, or quarter. In some cases, the interest rate adjust only upward -- that is, borrowers get no benefit if interest rates fall.
Why it Matters:
Interest-only mortgages are risky temptations and generally a bad idea. The typical strategy behind taking an interest-onlyis that the borrower does not have the to make a larger payment now but expects to have that later. If the interest rate is variable, sometimes the borrower also thinks that interest rates fall, making the payments lower later. Regardless, the borrower is not repaying any of the , and that simply keep generating interest due from the borrower until it is repaid.
Interest-onlycan have complex implications. Thus, as is the case with any or other , borrowers must be sure to read and understand the 's documentation and contemplate the implications of changes in interest rates. Borrowers should be sure they can handle the worst-case scenario of being forced to make the higher payments once they begin repaying the . In adjustable-rate mortgages, are legally required to disclose how high the borrower's monthly payment might go, and that the original is just going to keep accruing interest until it is paid.