Beware price shock with interest-only ARMs

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With the sharp spike in fixed mortgage rates between March and May, borrowers are increasingly looking for alternatives to traditional fixed-rate mortgages. Often, they are turning to hybrid adjustable-rate mortgages because they offer a lower initial rate than fixed-rate mortgages. But these hybrid ARMs also come in an interest-only variety. How do these interest-only hybrid mortgages compare to fully amortizing loans and what are the advantages and disadvantages?



As with hybrid ARMs, the initial interest rate is fixed for a period of years before becoming adjustable. Better still, this fixed rate is lower than that of a 30-year fixed-rate mortgage.



However, the monthly payment on an interest-only loan is comprised only of the interest due, with no principal component to the payment. While rates are still lower on these interest-only loans than on traditional fixed-rate mortgages, the rates are often one-quarter to one-half percentage point higher than those of fully amortizing hybrid ARMs.







Nonetheless, the monthly savings could be tempting. Comparing a fully amortizing 5/1 ARM at 4.89 percent with an interest-only 5/1 ARM at 5.01 percent, the difference in monthly payments on a $200,000 loan is $225 per month. This $225 in monthly savings represents skipping the principal repayment.



It is important to understand what corners are being cut to save money each month. The interest rate is higher on the interest-only loan, with the borrower paying a premium for the ability to make interest-only payments. The motivation for getting an interest-only hybrid lies in cutting the monthly payment by not paying down the principal.





Unlike other interest-only products, where the rate is often adjustable from the loan's inception and can change as frequently as every month, the interest-only hybrid offers a fixed rate and fixed interest-only payment during the early years of the loan.



Adding further appeal to wealthy homeowners and investors, the lower monthly payment does not come at the expense of the mortgage-interest tax deduction. Therein lies the advantage of an interest-only hybrid ARM -- lower monthly payments by virtue of paying interest and not principal, but without the interest rate and monthly payment volatility of a loan subject to rate adjustments from the get-go.



Both the fully amortizing and interest-only hybrid ARM products permit borrowers to select a mortgage suited to the intended period of ownership, and minimize the chances of ever facing a rate adjustment. But accurately defining the horizon of homeownership is critical. Failure to do so exposes the borrower to the risk of eventual rate adjustments and the possibility of higher monthly payments.



With interest-only loans, there is an additional risk of significant payment shock. At the end of the interest-only period, the loan principal then becomes amortized -- often over a period shorter than 30 years. Coupled with an upward rate adjustment, having to repay the principal in larger chunks can exact a harsh penalty for underestimating how long you plan to own the home.



Borrowers looking at interest-only hybrid ARMs on the basis of affordability have an additional reason to be careful. With the average household saving just over 2 percent of income, many households are saving little if any money each month. The only saving done each month in many of those households is building home equity through repayment of the mortgage principal. Cutting off this steady method of long-term wealth-building to make a particular home affordable in the short-term is a major warning signal.



Rates on fully-amortizing hybrid ARMs are still near 5 percent. If you have to resort to interest-only loans to afford the monthly payments when rates for fully-amortizing hybrid ARMs are this low, you can't afford the house.



Greg McBride is a senior financial analyst for Bankrate.com.