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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
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
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
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
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
1) Index: CMT-MTA-COFI-CODI-COSI-LIBOR-Prime
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
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
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
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:
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%
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.
A lower initial monthly payment.
Lower overall mortgage cost if you believe interest rates
will remain the same or decrease over the life of your loan. The
flip side is its obvious disadvantage; an unstable economy could
cause interest rates to increase, and you would pay more for your
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.
This is the predetermined period for which the rate of an ARM
is adjusted. For instance, a 3/1 ARM has a fixed rate for the first
three years of the loan and is then adjusted once every year through
the term of the loan to reflect the current economic conditions.
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%.