Example of an Interest Only ARM

One of many variants of an ARM is the interest only variety. These have become quite popular over the past 3-4 years. There are a number of reasons, the main one being: how else do you buy in a market with sky-high prices? They aren’t for everyone, of course, but for some of you they may be the only practical way to get an apartment in Manhattan.

Example 5: A 5-year interest-only loan on $100,000 at 5% will cost you $420 per month.

In Example 3, the traditional 30-year fixed rate version of this loan cost $600 per month (reflecting a 6% rate and amortization requirements). If we borrowed $800,000 under these traditional terms, the payment came to $4800 per month.

In this example of an interest only ARM at 5%, that same $800,000 loan will have a payment (fixed for 5 years) of 8 x $420 = $3360 per month.

Which do you prefer: an $800,000 loan with monthly payments of $4800 for 30 years or the same loan with payments of $3360 for 5 years?

And for further reference, at the "interest only" rate of 5%, you could borrow a little over $1,100,000 and not exceed a $4800 per month payment for the 5-year term. As with all ARMs, at the end of the fixed period, rates and payments adjust per the loan requirements.

In summary, we see that you have options that may allow the purchase of a more expensive apartment, relative to what you could buy if you stick with a conventional mortgage. Or, alternatively, you might choose an ARM simply as a way to reduce monthly expenses for the fixed term.

Note: we lowered our interest rate in Example 5 to 5%, because the rate for ARMs over the fixed period is usually lower than prevailing traditional 30-year rates. Click here for an interest only calculator to figure payments at different rates.

Some additional Details:

As the name implies, payments cover only the interest due each month. No portion of the payment is applied to principle for the fixed period – so your loan balance stays constant over this time frame (assuming you haven’t signed up for a version that allows for negative amortization). As is common with these loans, fixed periods of 3, 5, 7 and 10 years are typical. At the end of the initial period, the loan reverts to a standard ARM.

At this point the payment usually adjusts once a year per the underlying loan terms. Because the loan is now amortized, the principle balance starts declining.

Note: if, during the interest only phase, you choose to pay more than the minimum each month, the excess amount will be credited against the principle.

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