5/1 Interest Only ARM
The 5/1 interest only ARM is a loan that requires the borrower to pay only the interest on the loan that is due each month - for a period of five years. At the end of the five years, the loan is reset and the payments include a readjusted interest rate along with payment on the principal.
The interest-only ARM became popular during the great housing rush of 2000-2005 when people were scrambling to get into the housing market, and to buy as much house as the mortgage lenders would allow. The thinking behind this approach was that housing values were appreciating so rapidly that a loan - any loan - was acceptable. The continuing low interest rates and home appreciation would allow the borrower to refinance out of a loan such as the 5/1 interest only ARM at the five year mark and the gain in equity through appreciation would make it all worthwhile.
Most banks and lending institutions have a cap on the borrower's amount of monthly payment on debt that is acceptable - usually something like 38% of the monthly household income. Low initial mortgage payments make it possible for borrowers being awarded larger mortgages than they would qualify for if the interest rate was fixed. The interest only ARM is an example of a loan that is designed to present an extremely low initial payment schedule - and hence, a large mortgage and bigger house.
The obvious drawback on a 5/1 interest only mortgage is the sticker shock that comes with that adjustment at five years. The interest rate is going to rise a few points - and possibly quite a few points, depending on the terms of the loan. In addition, the monthly payment will now include money to pay off the loan principal. Finally, this loan has only 25 years remaining to pay off 100% of the principal.
Loans like this make sense in a market where homes are appreciating rapidly in value and when the borrower intends to sell the property or refinance it at the end of five years. If neither option is available for some reason, the new monthly payment can be a real challenge to the average homeowner.
The 5/1 interest only ARM also may be a reasonable choice for a young person or young couple who expect their household income to rise dramatically during that five year period. They may be in a position to handle the fully amortizing payment that comes due at the end of year five. Generally speaking however, the 5/1 interest only ARM is a delaying tactic that works for certain people in certain situations. It can also be an unfortunate enticement to others who cannot deal with the inevitable jump in the payment schedule.