You’re ready to buy a home, and this may or may not be your first rodeo. You’ve gone through the mental process of figuring out when the right time is, conducted research on the home-buying process, and put aside money for a down payment. Just as there are a number of reasons why you decided to buy a home, there are many ways of reaching that goal. In a typical home-buying situation, receiving keys to your new home starts when you get qualified for a home loan. A traditional mortgage may be the loan option that comes to mind first. With its fixed loan rate and steady payment amount for terms up to 30 years, this mortgage option is popular; however, in a one-size-does-not-fit-all world, there may be a better option for your situation. Putting aside time for researching additional home loan options is worth it, given the investment you’re making.
What is an interest-only home loan?
Just as the name suggests, an interest-only loan means that the borrower’s monthly payment amounts will only be applied toward the interest of the loan, not the principal balance, for a limited term (typically 5 or 10 years). That means that while the interest is being paid during those years, the principal balance remains unchanged. After the set term, the monthly payments will start to include both principal and interest. It’s good to keep in mind that while the required monthly payment is made up entirely of interest, a borrower can start to lower the principal balance before the end of the term, by making additional payments toward the principal balance as often as they’d like. In other words, any payment above the monthly minimum will begin to pay off the principal balance.
What is an ARM?
ARM is an acronym for adjustable rate mortgage. With an ARM, the interest rate is set at the initial/start rate for a specific initial period, such as the first 6 months, 1 year, 5 years, 7 years, etc., and then is variable for the remainder of the loan term. This means that the interest rate after the first period of time will fluctuate periodically (based on the terms of your loan agreement), either up or down, resulting in an increase or decrease to the monthly mortgage payment amount.
What is a 7/1 interest-only ARM?
Now, that you have a better understanding of interest only and ARMs, we’ll now mesh them together in a home loan option called a 7/1 interest-only ARM. With this home loan, the monthly mortgage payments are interest only for a period of 10 years. As mentioned earlier, this means that the principal balance of the loan remains unchanged for that length of time, unless the borrower chooses to make principal payments as well. The interest rate will be fixed for the first 7 years of the loan, and then will adjust annually for the remaining 3 years of the initial 10-year interest-only period. The fully indexed rate is defined as the index value plus the applicable margin.
Who might this option be a right fit for?
One of the perks of a 7/1 interest-only ARM is that the monthly payments are lower than one would pay on a traditional mortgage loan with the same principal balance, given the fact that the payments are interest-only. This may be a good fit for someone who favors lower monthly payments so that they can put any extra cash toward other investment opportunities, someone who has funds for a large down payment amount of more than 30%, or someone who knows they will not stay in the property for longer than the fixed interest period, or plans to payoff the loan or refinance before the fixed period ends. Finally, 7/1 interest-only ARMs may be fit for those who have commission-based salaries and want lower payments during slow months, but also want flexibility in making principal payments when they receive bonuses or higher pay from earned commissions.
What are the risks of an interest-only ARM?
Since the principal balance remains unchanged (unless the borrower specifically makes principal payments) during the course of the 10 years, the monthly payment amounts will likely be higher for the remaining 20 years of the loan. This, combined with the fact that life is unpredictable and what’s affordable today may not be in 10 years, is the biggest risk of not paying toward the principal.
Another risk associated with this loan product is that after 7 years of making payments based on a steady rate, the rate can fluctuate periodically for the remaining loan term. The rate may decrease, which will lower the payment, but they may also increase too, causing an increase in monthly payments. While there is a cap to how much the rate can increase by over the course of the loan, borrowers may find they need to adjust spending habits to compensate for any increases. Many people get an interest only loan expecting the market to go up and give them equity, but if the market goes down, the borrower is left in a situation where equity is negative.
How to estimate monthly payments and interest
As part of your 7/1 interest-only ARM exploration, try out two of our calculators linked below. After generating results, click Detailed Results for an additional breakdown of payments and interest by year.
Remember, we're here to help answer any questions you have about buying a home. While it's an exciting time, we understand it also comes with added stress. Having been around the block (pun intended) quite a few times in our history, we're happy to help you find your perfect mortgage match.
The Logix 7/1 Interest-Only ARM is a 30-year Adjustable Rate Mortgage loan that permits interest-only payments for the first 10 years, with required principal and interest monthly payments fully amortized over the remaining 20 years of the loan term, for the purchase and limited cash-out refinancing of owner-occupied single family, condominium, and PUD primary residence properties up to a maximum 70% Loan to Value (LTV). Interest-only payments during the first 10 years do not reduce the principal balance on the loan. The start rate for the 7/1 ARM is fixed for the first 7 years, thereafter, the rate can adjust every 12 months. ARMs are variable-rate loans and the Annual Percentage Rate (APR) can increase after consummation. If the APR increases, your loan payment will increase.
The Logix Interest Only mortgage is not for everyone. It’s a nontraditional mortgage that’s for a very specific type of buyer. If you are a real estate professional looking to get a client into an interest-only ARM or a potential buyer, we’d love to tell you about the Logix 7/1 I.O. ARM.