Interest-only ARM? An interest-only ARM requires only interest payments during an initial period, typically 5 to 10 years. After that, payments become fully amortizing covering both principal and interest. Payment shock is a significant risk when the IO period ends.
How an Interest-Only ARM Works
During the interest-only period, you pay only the interest on the loan. The principal balance does not decrease. This keeps monthly payments low initially but means you are not building equity through amortization. If the property value stays flat, you could owe as much as you borrowed even after years of payments.
IO ARMs typically have a fixed period like a hybrid ARM, but during that period only interest is due. After the fixed period or IO period ends, the loan recasts to fully amortizing over the remaining term, and the payment increases substantially.
Risks of Payment Shock
Payment shock is the dramatic increase in monthly payment when the IO period ends. A payment that was $1,500 per month could jump to $2,500 or more depending on the remaining balance, interest rate, and amortization schedule. This risk is compounded if rates have risen by the adjustment date.
Patrick Kevin Fagan generally cautions first-time homebuyers against IO ARMs unless they have a clear plan to sell, refinance, or handle the higher payments before the IO period expires.
