What is an Interest-Only ARM?

An interest-only adjustable-rate mortgage (interest-only ARM) is a mortgage in which the borrower only pays the interest on the loan for a set period.

How Does an Interest-Only ARM Work?

There are two parts to an interest-only ARM that differentiate it from traditional mortgages. First, as mentioned, the borrower only pays the interest on the loan for a set period. That’s the “interest-only” part. Second, that interest rate varies. That’s the “ARM” part.

The interest rate on the ARM corresponds to a specific benchmark (often the prime rate, but sometimes LIBOR, the one-year constant-maturity Treasury or other benchmarks) plus an additional spread (which is also called the margin, and its size is often based on the borrower's credit score). The benchmark plus the spread equals the interest rate on the loan: It is called the fully indexed rate. Some ARMs offer a discounted index rate, also called a teaser rate, during the first year or so.

To understand how adjustable interest rates affect a borrower's payment, let's assume a bank offers a $100,000 ARM to a potential borrower. The interest rate is prime plus 5% with a cap of 10%. If the prime rate is 3%, then in a regular mortgage (in which part of the payment is the repayment of principal) the borrower's interest rate is 8% (5% + 3%), and the monthly payment is $733.77. But in an interest-only ARM, the payment is only the interest portion: $666.67. This reduces the borrower's payment, but it leaves the principal outstanding (and accruing more interest).

If the prime rate increases to, say, 4%, then the loan's interest rate goes to 9% (5% + 4%), and the interest-only payment goes to $750. In many cases, ARMs have caps -- limits on how high and sometimes how low the interest rate can go, and how much they can move in any one year, month or quarter. In some cases, the interest rate will only adjust up -- that is, borrowers will get no benefit if interest rates fall.

Why Does an Interest-Only ARM Matter?

Interest-only ARMs are risky temptations, and generally a bad idea. The typical strategy behind taking an interest-only ARM is that the borrower does not have the income to make a larger payment now but expects to have that income later. Sometimes the borrower also thinks that interest rates will fall, making the payments lower later.

For example, if a borrower takes an interest-only ARM that currently carries a 7% interest rate, he is hoping that rates will drop and his payments will fall accordingly. The lender, on the other hand, is hoping interest rates will increase, which raises the amount of profit the loan generates (by increasing the borrower's payments). Because of this risk arrangement, ARMs often carry lower interest rates than fixed-rate mortgages, which in turn might allow borrowers to borrow more than they could under fixed-rate mortgages.

As you can see, interest-only ARMs can have complex implications. Thus, as is the case with any mortgage or other loan, borrowers must be sure to read and understand the lender'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 highest mortgage payments allowed. Lenders are legally required to disclose how high the borrower's monthly payment might go, and that the original principal is just going to keep accruing interest until it is paid.