What Is an Interest-Only ARM and How Does It Work?

An interest-only adjustable-rate mortgage (ARM) allows borrowers to pay only the interest for a set period before transitioning to payments that include both principal and interest. This results in lower initial monthly payments, making it appealing for those managing short-term costs. However, once the interest-only phase ends, payments typically increase, sometimes significantly.

Understanding how these loans function—including rate adjustments, qualification requirements, and potential risks—is essential for anyone considering this option.

How the Interest-Only Period Works

During the initial phase, borrowers pay only the interest accrued on the loan balance each month. This period typically lasts between five and ten years, depending on the loan terms. Since no principal is paid down, the loan balance remains unchanged unless the borrower makes extra payments.

For example, a borrower with a $400,000 loan at a 5% interest rate and a 10-year interest-only period would pay approximately $1,667 per month. This payment covers only interest, meaning the borrower will still owe $400,000 when the interest-only phase ends.

This structure provides flexibility, allowing borrowers to allocate funds elsewhere, such as investments or savings. Some may choose to make voluntary principal payments, but they are not required. However, because the loan balance does not decrease through regular payments, borrowers do not build equity unless property values rise or they make extra payments.

The Adjustable Rate Structure

Once the interest-only phase ends, the loan transitions to an adjustable-rate period where payments fluctuate based on market conditions. The interest rate is no longer fixed, meaning monthly payments can rise or fall depending on economic factors. Adjustments typically occur annually or semi-annually and are tied to a financial benchmark.

Lenders impose rate caps to limit volatility:

– Initial adjustment cap – Limits the first rate increase after the interest-only phase.
– Periodic adjustment cap – Restricts subsequent rate changes.
– Lifetime cap – Sets the maximum possible rate increase over the loan’s duration.

For example, a 2/2/5 cap structure means the rate can increase by up to 2% at the first adjustment, 2% at each subsequent adjustment, and no more than 5% over the life of the loan.

If interest rates rise significantly, borrowers may experience a sharp increase in monthly payments. Some refinance into a fixed-rate mortgage before adjustments begin to secure predictable payments, though this depends on prevailing interest rates and individual financial circumstances.

Loan Index and Margin Elements

The interest rate on an interest-only ARM is determined by two components: the loan’s index and margin.

– Index – A benchmark interest rate that fluctuates based on market conditions.
– Margin – A fixed percentage set by the lender that remains constant throughout the loan’s term.

Common indices include:

– Secured Overnight Financing Rate (SOFR) – Reflects short-term borrowing costs in U.S. financial markets.
– Constant Maturity Treasury (CMT) rate – Based on U.S. Treasury yields.
– 11th District Cost of Funds Index (COFI) – Moves more slowly as it reflects savings institution costs.

For example, if an ARM uses SOFR as its index and the lender’s margin is 2.5%, and SOFR is at 3%, the borrower’s new rate would be 5.5%. Margins vary based on creditworthiness, loan-to-value ratio, and lender policies. A borrower with strong financials may secure a lower margin, reducing overall borrowing costs.

Qualification and Eligibility Criteria

Lenders evaluate financial stability and risk tolerance when assessing eligibility for an interest-only ARM.

– Credit Score – Typically, a FICO score of at least 700 is required. Borrowers with lower scores may still qualify but could face higher margins or require larger down payments.
– Debt-to-Income (DTI) Ratio – Generally must stay below 43%, though high-income applicants with substantial assets may receive exceptions.
– Affordability Assessment – Lenders may apply a stress test, calculating affordability based on the fully indexed rate rather than the initial payment amount.

Because initial payments are lower, some borrowers qualify more easily than they would for a fully amortizing loan. However, lenders also assess whether borrowers can afford payments once the interest-only period ends.

Payment Reset Phase

Once the interest-only period ends, the loan transitions to a fully amortizing structure, requiring both principal and interest payments. Since the remaining balance must be repaid over a shorter period, monthly payments increase.

For example, if a borrower took out a 30-year loan with a 10-year interest-only phase, they would have 20 years to pay off the full principal. This results in higher monthly obligations. The new payment is calculated based on the outstanding balance, current interest rate, and remaining loan term.

If interest rates have risen, borrowers may struggle with the increased payments. Some refinance into a fixed-rate mortgage before the reset to secure predictable payments, while others opt for another ARM if they plan to sell the property before further rate adjustments. Lenders may require proof of affordability before the reset occurs, which can be challenging if income has not kept pace with rising costs.

Common Costs and Fees

Interest-only ARMs come with various costs beyond monthly payments.

– Origination Fees – Often higher than those for fixed-rate mortgages due to the lender’s increased risk.
– Discount Points – Optional upfront payments to secure a lower interest rate.
– Prepayment Penalties – Some lenders charge fees if the loan is refinanced or paid off early.
– Closing Costs – Typically range from 2% to 5% of the loan amount.

Borrowers should also consider the impact of annual rate adjustments, which may lead to higher payments even if initial terms seem favorable. Understanding these costs helps borrowers determine whether an interest-only ARM aligns with their financial goals.