Interest-only ARM: What it is and how it works

Quick insights

When it comes to choosing a mortgage, the options may feel overwhelming. With all kinds of acronyms, numbers and documents to deal with, knowing which loan is a good fit for you can feel challenging.

If you’re searching for a way to manage your monthly payments, especially during the early years of your loan, an interest-only adjustable-rate mortgage (or an “interest-only ARM”) might be a good choice. Though not ideal for everyone, this unique mortgage type holds potential benefits for certain financial situations.

Let’s take a closer look.

What is an interest-only ARM?

An interest-only ARM (adjustable-rate mortgage) allows you to make payments solely toward the loan’s interest for a set period of time (generally 10 years or less). During this time, your monthly payments are relatively low compared to other loan types because you’re not contributing toward paying down the loan’s principal.

Once the interest-only period ends, you’ll start paying both the principal and interest, which can cause your monthly payment to increase significantly.

It may help to think of an interest-only ARM as a two-phase loan:

ARM loans aren’t the only kind that can exist as interest-only. There are also interest-only fixed-rate mortgages. The difference is that ARMs have an initial fixed-rate period (usually three, five, seven or 10 years), often with a lower rate than fixed loans at the start. After the initial period, the interest rate adjusts based on rates tied to market trends.

Examples of an interest-only mortgage loan

Let’s say you borrow $300,000 with a seven-year interest-only ARM at a 5% interest rate for a 30-year mortgage. You’ll pay about $1,250 per month during the first seven years. Following this period, payments will then include both principal and interest, so your monthly costs will rise.

This setup provides flexibility early on, allowing you to allocate money elsewhere—whether that’s toward investments, other debts, a temporary financial goal or challenge.

What are interest-only ARM rates?

Interest-only ARM loans tend to follow the same interest rates as their principal-paying counterparts. There’s generally no difference, for example, in how the interest rate works for an interest-only ARM compared to a regular ARM.

ARMs may appeal to you as a homebuyer with their lower initial rates, but remember that the rates adjust later. Because the rates adjust based on market rates, you could find yourself paying significantly higher interest rates once you move out of the initial fixed period.

Why choose an interest-only ARM?

There are a few reasons why someone might choose an interest-only ARM over the alternatives:

Keep month-to-month housing costs low

These loans can help buyers looking for lower initial payments to manage short-term cash flow. This is a benefit of ARM loans in general that tends to be amplified with interest-only mortgages in particular. Note that this may also be a benefit if you’re hoping to manage overall cash flow.

Afford a pricier home

In some cases, an interest-only loan may allow you to buy a more expensive property because the initial monthly payment obligations are lower. If you’re considering a jumbo loan, an interest-only jumbo ARM might be a good choice for you.

Not looking to stay in a home for the long-term

If the home you’re buying isn’t your “forever home,” or if you happen to be a real estate investor, an interest-only ARM could be a good option. Because you’ll be selling or refinancing before the adjusted rate kicks in, you’ll likely benefit from the lower payments.

Buying a second home

Interest-only loans are a handy option for aspiring second-homeowners who aren’t living in the second home full-time yet.

Pay it off faster than a conventional loan

When you take out a conventional loan, extra payments may be able to help you reduce the overall principal, but your monthly payments will remain the same. If, however, you can make extra payments toward an interest-only loan, the lower principal could result in a lower payment each month.

Potential lower rates

Since rates for these types of loans aren’t fixed, they adjust with the market. This means borrowers can stand to benefit if rates decline in the future.

Do banks still offer interest-only mortgages?

Banks still offer interest-only mortgages, but they’re not as common as traditional fixed-rate or standard ARMs. After the 2008 financial crisis, lenders tightened their guidelines significantly, making interest-only loans less accessible.

That said, as long as you meet the qualifications and understand the potential risks, interest-only ARMs remain an option. These requirements can differ from those for traditional fixed-rate loans and vary by lender. Ultimately, lenders want to ensure borrowers can manage the financial responsibility an interest-only ARM brings.

What are disadvantages of an interest-only mortgage?

While interest-only ARMs can be appealing for their initial low payments, there are several potential drawbacks.

Risk

Again, interest-only ARMs can leave borrowers vulnerable if interest rates increase, home values fall or if your refinance options become limited later on.

Not building equity

For the first several years, you’re only paying off the interest, not the principal. This means you’re not building equity, leaving little financial payoff unless your home’s value appreciates significantly.

Losing equity gained from payment if home value declines

If property prices dip, you could owe more than what your home is worth. This scenario, often referred to as being “underwater,” could make selling or refinancing very difficult.

Low payments only temporary

Sure, the initial payments are lower, but this comes to an end when the interest-only period expires. Once you start paying both principal and interest, your monthly bill can rise dramatically, potentially straining your finances.

It’s possible you’ll also end up paying more overall with an interest-only ARM than with a conventional mortgage. This is because of variable rates and the fact that you’re only paying interest, not principal, so the loan balance remains the same.

There’s also the potential for a balloon payment. If your loan terms include a balloon payment, you could be required to make a significant lump-sum payment at the end of the interest-only period. Balloon payments can be tens of thousands of dollars, which may overwhelm unprepared borrowers.

Interest rates can rise

Interest-only ARMs come with variable rates, which means your payments can increase significantly if interest rates rise during your home loan term. This unpredictability can make budgeting a challenge for some homeowners.

In summary

Interest-only ARMs offer a unique approach to home financing, giving borrowers flexibility with lower upfront payments and potentially more cash for other investments. However, they also carry risks, including interest rate changes and the potential for much higher payments down the road.

If you’re considering an interest-only ARM, be sure you have a clear understanding of your financial future. Are your earnings likely to increase significantly? Do you have a plan for when the interest-only period ends? These are questions every borrower must answer with confidence before signing on the dotted line.

Still curious about whether an interest-only ARM is a good fit for your financial goals? Explore your options, discuss them with a trusted advisor and ensure you’re informed before making this significant investment.