Interest Only Loan

In an interest only loan the borrower only has to pay the interest on the principle balance unchanged for a set of terms as well as tenure. At the end of this the borrower may enter an interest-only mortgage agreement, pay the principal or convert the loan to a principal and interest payment.

An interest only loan can be useful and fit for -
" People with income in form of infrequent commissions or bonuses
" People who expect to earn a lot more in few years
" People who truly invest their savings on the difference between an interest-only mortgage and an amortizing mortgage.

The interest only loan term and conditions varies from one country to another. In United States of America, this loan is typically for a five year or ten year interest-payment. Once the time is over, the principal balance is amortized for the rest of the term. The early payment in this case is substantially low than the later payments. This gives the borrower a flexible deal, as they are not forced to make payments towards principal. it also enables a borrower to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford, or investors to generate cashflow when they might not otherwise be able to. During this period, the loan balance is not decreased untill the borrower makes the aditional payment toward principal.

In United Kingdom, things are little different. Here interest only loan are popular ways of borrowing money to buy any particular asset which is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. Many of these endowment policies also cover the mortgage and provide a lump sum in addition.

In Canada, the interest only loans allow the borrower to pay an extra twenty percent interest along with the interest-only, principal and interest, or even principal. In Canada, this can also be combined  with corporate bonds in RRSP (Registered Retirement Savings Plan).

But if you are an invester you should keep in mind that the interest only loans are many a time generated artificially. A pool of securities are created and divided into trances. The cashflows are spread through the tranches according to predefined rules. These are the type of trances that can be created in tandem with a principle only tranche.

Interest only loan also helps the home owners to afford more homes and earn more appreciations during the tenure. These loans have also contributed greatly to create the current housing situations as many borrowers can not afford the full indexed tax rate. But one should also keep in mind that an interest only loan can be a real bad decision if the price of the house drops. This may cause the borrowers to carry a larger mortage than the real value of the house that may in turn lead to refinancing the house into a fixed rate mortgage causing major dent in finances.

Example, if a 30-year fixed-rate loan of $100,000 at 8.5% is interest only, the payment is .085/12 times $100,000, or $708.34. This is an example of interest only payment.

Each loan payment consists of Interest and Principal. Here you will be paying an interest each month and your principal will be adding to your balance, thus increasing it. You may also pay both principal and interest.

Interest only Loans have these options:

1) Index: CMT-MTA-COFI-CODI-COSI-LIBOR-Prime Rate

2) Margin: Is given to you by your lender, and it is the difference between the index rate and the interest charged to the borrower.

For example 5/1 ARM. This loan is fixed for 5 years after which in 6th year it becomes an adjustable loan.  Your loan officer will tell you what your index is and what your margin is. Usually 5/1 arm is tied to 1-year treasury index and margin is around 2.00%-3.00%

Your index + margin = Fully Index rate . Your new note rate (interest rate) after 5th year.

What about the 6th year? What would your payment be?

Let's say that your loan officer told you that your margin is 2.5% with 1 year treasury index. You will have to look up 1 year treasury index for a specific month.

1 year treasury as of Oct.2005 is 4.18, and you know that your margin is 2.5%. Therefore you new interest rate is 1 year treasury 4.18% (index) + 2.5% (margin) = 6.68% for the beginning of 6th year.

Index rate are move on monthly basis, therefore your payment may fluctuate each month. In most cases banks wills end you a statement advising you that your rate will change.

3) To protect consumers from high index rates, lenders implemented a CAPS.

An example of this is a 2/6 cap, which allows the interest rate on your ARM loan to go up or down by no more than two percent every adjustment period, and has a total limit of six percent for cumulative changes. Therefore a 2/6 cap on a 5% ARM will allow a maximum rate (6 + 5%) of no more than 11%.

In some cases you will see 2/2/6, which means 2% adjustment with 2 year prepayment penalty and total of six percent of cumulative changes.

How is an ARM loan different from a Fixed Rate loan?

ARM stands for Adjustable Rate Mortgage. The interest rate used to figure the payment "adjusts" according to a specific financial index. Therefore your loan payment may increase or decrease after the loan is closed. An ARM is often more attractive than other loan scenarios due to an initial lower interest rate and payment amount.

By contrast, a fixed rate loan has an interest rate that remains constant throughout the term of the loan.

How is an ARM interest rate determined?

Interest rates on ARM loans are usually based on an "index" with the addition of a "margin."

INDEXES
An ARM index typically relates interest rates to general economic conditions at any given time. Interest rates most accurately reflect the mortgage lender's "cost of funds." As the interest index rises and falls, reacting to the economy, the lender's costs mirror the index requiring that ARM rates change as well. Some examples of ARM indexes include the Wall Street Journal Prime Rate and the average yields on U.S. Treasury Securities.

You will find some ARM loans which are adjusted by the lender to reflect market conditions rather than indexes. Generally, their rates are comparable to loans tied to an index. Competition keeps them from getting out of line.

MARGINS
As mentioned before, a margin is usually added to an ARM interest rate when it is tied to an index. The margin is a pre-determined amount that is added to (or, in some cases, subtracted from) an index value to arrive at the interest rate. For example:

Index @ 5.50% + Margin @ 2.50% = 8.00% Interest Rate

Using the formula in this example, if the index value fell below 5.25% at your next interest rate adjustment, the interest rate on your ARM may fall in your favor to 7.75%. Often the interest rate is subject to "rounding," a pre-set increment adjustment. For example, the interest rate may round to the nearest one-eighth of one percent (0.125%). Therefore, if the index were 5.48, it would become 5.50%.

How are adjustments controlled?

When investigating an ARM loan, you'll notice that it is subject to "caps" which determine the amount and timing of adjustments to the interest rate.

LIFE CAPS
Because our economy is volatile, ARM loans can be subject to significant interest rate changes over the life of the loan. As a result, the Truth-in-Lending law requires a "life cap" - the maximum rate of interest that can be charged for a particular ARM loan - be clearly identified to the borrower. This life cap is determined when the loan is made and is expressed either as a predetermined maximum rate of interest or as the maximum amount of change over the initial interest rate.

Using our example above, an initial ARM interest rate of 8.00% can have a life cap expressed as a maximum rate (as an example 12.00%) or a maximum percentage change (as an example of a 5.00% maximum change, 8.00% initial interest rate + 5.00% = 13.00% cap).

ADJUSTMENT CAPS
In addition to life caps, some ARM loans may have an 14 adjustment cap." This is a limit on the amount the loan interest rate can change at any one time (the frequency of the adjustment period is determined when the loan is made, but typically there is an annual adjustment).

A common adjustment cap is 2.00%, although a different percentage may be specified. Using our example of an initial 8.00% mortgage rate, with a 2% cap, the first interest rate adjustment could go no higher than 10.00%, or no lower than 6.00%, even if the index were to change more than 2.00% during the adjustment period. The second and subsequent adjustment(s) will be subject to the 2.00% cap, but now use the interest rate of the last adjustment period. The purpose of an adjustment cap is to minimize the financial impact of index changes to a loan in any one period.

PAYMENT CAPS
An alternative to an adjustment cap is a "payment cap." This is a limit on the amount or percentage that a payment may change at each adjustment. If this cap was 7.50% and your monthly payment was $800.00, the most your payment could increase would be $60.00 - to $860.00. At the next adjustment, the most your payment could increase would be $64.50 (7.50% of $860.00 - for a $924.50 payment this period).

Note: If your loan has a payment cap, check for the potential of "negative amortization." This occurs when the interest index has increased faster than your payment's ability to absorb all of the interest now accruing on your mortgage. This excess interest not paid is added back to the principal and you end up owing more at the end of the loan.

A FINAL COMPARISON
Because there are so many different ARM programs, we strongly recommend you allow us to explain them to you in more detail. In a final note, a ARM loan can offer several advantages to the borrower.

A lower initial interest rate as compared to a fixed rate loan.

In addition to this brochure, federal law entitles you to a detailed disclosure of any ARM program. "ARMed" with this information and the counsel of your loan officer, you will be able to determine the potential course of an ARM loan over its life and make an informed decision if an adjustable rate mortgage is right for you.

Examples:

Adjustment Period

Caps
This is a limit specified in the ARM loan for individual and cumulative interest rate adjustments. An example of this is a 2/6 cap, which allows the interest rate on your ARM loan to go up or down by no more than two percent every adjustment period, and has a total limit of six percent for cumulative changes. Therefore a 2/6 cap on a 5% ARM will allow a maximum rate of no more than 11%.

Index
The measurement, or basis, that lenders use to adjust the interest rate on an ARM. ARMs are usually quoted with a "teaser", or first-year rate, and then expressed as an index plus a margin. For instance, a 5/1 ARM may be advertised at 5% with a 2.5% margin over the U.S. 30-year bond index. This means that your first year's rate would be 5%. The second year, the rate would be 2.5% plus whatever the 30-year bond rate was, such as 6%, making your rate through year five equal to 8.5%. In year five, your rate is adjusted again, this time to 2.5% plus the current 30-year bond rate, now 7%, making your new rate equal to 9.5%.