3/1 Interest Only ARM
The interest only ARM is an ingenious bit of financial juggling that is designed to provide borrowers with an extremely low mortgage payment for the initial period of the loan - usually some number of years. The low payment allows borrowers to qualify for a larger loan than would be available to them under the terms of a standard ARM or a fixed rate mortgage. That in turn leads to the maximum in house value - and for the initial period of the loan, new homeowners making monthly payments on a house that they probably thought was beyond their reach.
A low payment schedule in the loan's early years allows borrowers to meet the ceiling that lenders allow borrowers to maintain for total household debt service. Usually the acceptable maximum debt service for a potential borrower must be under 40% of the household's total income. For the borrower, however, the real question that he/she must ask is "Can I afford the payments when the loan adjusts?"
A 3/1 interest only ARM is a loan that requires three years of monthly payments solely on the interest. It's a good choice for someone who believes that the household income is going to rise substantially within the next few years, either through a new job or through the inclusion of additional breadwinners in the family.
People who bump the schedule to a 5/1 interest only ARM and pay mere interest for the first five years of the loan often intend to either sell the property or refinance it at five years. A three year period is probably too short for either of these choices to make sense, so the borrower who is contemplating taking a 3/1 interest only ARM needs to consider the consequences of paying on the fully adjusted mortgage.
The current interest rate today, (a May day in 2007) is 5.60% on a 3/1 interest only ARM. On a $300,000 loan, that will require a monthly mortgage payment of $1400. Make the assumption that your 3/1 has an index based on the one year Treasury bill and a margin of 2.5%. That means that beginning with the first month of year four in your mortgage, the monthly payment will be calculated by adding the interest rate on a one year T-bill for that particular day to your margin. Margins are usually two to three percent; we'll assume that for this loan the margin is 2.5%. The T-bill interest rate today is 4.90%. If today was the adjustment day for your $300,000 loan the interest rate would jump to 7.4% and you would begin making payments on the loan principal as well. The result would be a monthly payment of $2142.
That's an increase of over 50%. It's the real number that you will have to deal with during 27 of the 30 years on the mortgage, and it is payments in that range that you should plan for. You've got three years to plan that new budget.