Interest-only loan

An interest-only loan is a loan in which, for a set term, the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.

In the United States, a five- or ten-year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because he is not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase his salary substantially over the course of the loan to borrow more than he would have otherwise been able to afford, or investors to generate cashflow when they might not otherwise be able to. During the interest-only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that applies to principal is significantly smaller than the portion that applies to interest in the early years (the same period of time that would be interest-only).

Interest-only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, theadjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk—especially when that buyer is unlikely to qualify under more conservative loan structures. Because a homeowner does not build any equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time he is either ready to sell the house or refinance. He may find himself unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.

Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts such as Suze Orman advise against interest-only loans for which a borrower would not otherwise qualify. The types of interest-only loans that rely on home appreciation would be negative amortization loans, which most financial institutions discontinued in mid-2008.

A recent study published by the Federal Reserve Bank of Chicago verified that most Americans can benefit from funding tax deferred accounts rather than paying down mortgage balances. Homeowners sometimes use interest-only loans for freeing up monthly cash to fund retirement accounts. 3.4 million households don't contribute at all to their retirement but do accelerate the pay down of their mortgages. "Those households are losing from 11 to 17 cents for each dollar they put into a faster mortgage payoff", per a Chicago Federal Reserve study reiterated in the Chicago Tribune.

UK interest-only mortgages

Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest-only loan with an endowment policy, the combination being known as an endowment mortgage. Homeowners were told that the endowment policy would cover the mortgage and provide a lump sum in addition. Many of these endowment policies were poorly managed and failed to deliver the promised amounts, some of which did not even cover the cost of the mortgage. This mis-selling, combined with the poor stock market performance of the late 1990s, has resulted in endowment mortgages becoming unpopular.

Canada rarely allows interest-only loans

It is possible, though extremely rare, to obtain a Canadian Interest Only payment or first few payments on a standard amortizing mortgage.

Interest-only loans in India

After the entry of private banks into the Indian banking sector, which was earlier dominated by nationalized banks, interest-only loans have been introduced. These loans are given provided that the borrower hands over a security (like gold ornaments) or the documents of the same (house papers) to the bank. Gold loans are the most common interest-only loans in India.

Interest-only mortgages in Singapore

In Singapore, interest-only mortgages had been dis-allowed since 14 September 2009. The reason for this was because this type of mortgage encouraged property speculations. Buyers will buy a private house while it is still under construction, and pay only the interest of the mortgage until the property is completed. Due to the lower monthly repayment (interest only) during the construction phase, some investors, thus, will acquire the house with the intention of selling it at a profit before the construction is completed.

From an investor's perspective

Interest-only loans are sometimes generated artificially from structured securities, particularly CMOs. A pool of securities (typically mortgages) is created, and divided intotranches. The cashflows that are received from the underlying debts are spread through the tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally created in tandem with a principal only (PO) tranche. These tranches will cater to two particular types of investors, depending on whether the investors are trying to increase their current yield (which they can get from an IO), or trying to reduce their exposure to prepayments of the loans (which they can get from a PO). The investment returns on IOs and POs depend heavily on mortgage prepayment rates and permit investors to benefit from different prepayment expectations.

Many homeowners saw the values of their homes increase by as much as four times its price in some markets in a five-year span in the early 2000s. Interest-only loans helped homeowners afford more home and earn more appreciation during this time period. However, interest-only loans have contributed greatly to creating the subsequent housing bubble situation, because many borrowers could not afford the fully indexed rate. Interest-only loans may turn out to be bad financial decisions if housing prices drop, causing those borrowers to carry a mortgage larger than the value of the house, which in turn will make it impossible to refinance the house into a fixed-rate mortgage.

A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market or index the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate(LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is distinct from the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include theinterest-only mortgage, the fixed-rate mortgage, the negative amortization mortgage, and the balloon payment mortgage.

Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases. The borrower benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.

Caps

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:

• frequency of the interest rate change
• periodic change in interest rate
• total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of interest rate adjustment caps:

• interest adjustments made every six months, typically 1% per adjustment, 2% total per year
• interest adjustments made only once a year, typically 2% maximum
• interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:

• maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative amortization loans

Life of loan interest rate adjustment caps:

• total interest rate adjustment limited to 5% or 6% for the life of the loan.

Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.

Although uncommon, a cap may limit the maximum monthly payment in absolute terms (for example, $1000 a month), rather than in relative terms.

ARMs that allow negative amortization will typically have payment adjustments that occur less frequently than the interest rate adjustment. For example, the interest rate may be adjusted every month, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.

Reasons for ARMs[

ARMs generally permit borrowers to lower their initial payments if they are willing to assume the risk of interest rate changes. There is evidence that consumers tend to prefer contracts with the lowest initial rates, such as in the UK where consumers tend to focus on immediate monthly mortgage costs. Decisions of consumers may also be affected by the advice they get, and much of the advice is provided by lenders who may prefer ARMs because of financial market structures.

In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset–liability mismatch due to interest rate risk: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and were caught when Paul Volcker raised interest rates in the early 1980s. Therefore, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.

Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets). To reduce this risk, many mortgage originators will sell many of their mortgages, particularly the mortgages with fixed rates.

For the borrower, adjustable rate mortgages may be less expensive, but at the price of bearing higher risk. Many ARMs have "teaser periods", which are relatively short initial fixed-rate periods (typically one month to one year) when the ARM bears an interest rate that is substantially below the "fully indexed" rate. The teaser period may induce some borrowers to view an ARM as more of a bargain than it really represents. A low teaser rate predisposes an ARM to sustain above-average payment increases.

ARM Variants

Hybrid ARMs

A hybrid ARM features an interest rate that is fixed for an initial period of time, then floats thereafter. The "hybrid" refers to the ARM's blend of fixed-rate and adjustable-rate characteristics. Hybrid ARMs are referred to by their initial fixed-rate and adjustable-rate periods, for example, 3/1, is for an ARM with a 3-year fixed interest-rate period and subsequent 1-year interest-rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM.^[

The popularity of hybrid ARMs has significantly increased in recent years. In 1998, the percentage of hybrids relative to 30-year fixed-rate mortgages was less than 2%; within six years, this increased to 27.5%.

Like other ARMs, hybrid ARMs transfer some interest-rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate in many interest-rate environments.

Option ARMs

An "option ARM" is typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment.

These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

When a borrower makes a Pay-Option ARM payment that is less than the accruing interest, there is "negative amortization", which means that the unpaid portion of the accruing interest is added to the outstanding principal balance. For example, if the borrower makes a minimum payment of $1,000 and the ARM has accrued monthly interest in arrears of $1,500, $500 will be added to the borrower's loan balance. Moreover, the next month's interest-only payment will be calculated using the new, higher principal balance.

Option ARMs are often offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first year of the ARM. During boom times, lenders often underwrite borrowers based on mortgage payments that are below the fully amortizing payment level. This enables borrowers to qualify for a much larger loan (i.e., take on more debt) than would otherwise be possible. When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the "mortgage margin" that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is "payment shock", when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

The minimum payment on an Option ARM can jump dramatically if its unpaid principal balance hits the maximum limit on negative amortization (typically 110% to 125% of the original loan amount). If that happens, the next minimum monthly payment will be at a level that would fully amortize the ARM over its remaining term. In addition, Option ARMs typically have automatic "recast" dates (often every fifth year) when the payment is adjusted to get the ARM back on pace to amortize the ARM in full over its remaining term.

For example, a $200,000 ARM with a 110% "neg am" cap will typically adjust to a fully amortizing payment, based on the current fully indexed interest rate and the remaining term of the loan, if negative amortization causes the loan balance to exceed $220,000. For a 125% recast, this will happen if the loan balance reaches $250,000.

Any loan that is allowed to generate negative amortization means that the borrower is reducing his equity in his home, which increases the chance that he won't be able to sell it for enough to repay the loan. Declining property values would exacerbate this risk.

Option ARMs may also be available as "hybrids," with longer fixed-rate periods. These products would not be likely to have low teaser rates. As a result, such ARMs mitigate the possibility of negative amortization, and would likely not appeal to borrowers seeking an "affordability" product.

Cash flow ARMs

A cash flow ARM is a minimum payment option mortgage loan. This type of loan allows a borrower to choose their monthly payment from several options. These payment options usually include the option to pay at the 30-year level, 15-year level, interest only level, and a minimum payment level. The minimum payment level is usually lower than the interest only payment. This type of loan can result in negative amortization. The option to make a minimum payment is usually available only for the first several years of the loan.

Cash flow ARM mortgages are synonymous with option ARM or payment option ARM mortgages, however it should be noted that not all loans with cash flow options are adjustable. In fact, fixed rate cash flow option loans retain the same cash flow options as cash flow ARMs and option ARMs, but remain fixed for up to 30 years.

Loan caps

Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2–3% above the Start Rate on a loan with an initial fixed rate term of three years or lower and 5–6% above the Start Rate on a loan with an initial fixed rate term of five years or greater.

Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of three years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of five years or greater.