Because there are so many different types of Interest-Only ARMs, we will break them down into 3 main categories for further discussion based upon the Fixed-Rate Period that each type offers: Long-term, Short-term and HELOC-based.

LONG-TERM I-O ARMS (Risk Tolerance: LOW)

Long-term ARMS are products that generally feature long, introductory fixed-rate periods that range from 5 to 10 years. With these products, you generally select a Fixed-rate period that matches your anticipated occupancy period. If you expect to be in the house for 4 years, you select a 5-year ARM to ensure that the payment remains fixed during the entire expected occupancy period, making it a good choice for those with less risk tolerance.

Most consumers who use this strategy rarely look at the Index and Margin because they do not expect to be in the home when the adjustment period occurs, thus making those features far less important.

Long-term ARMS are generally connected to either the LIBOR (London InterBank Offered Rate) or T-Bill (U.S. Treasury Bill) index. If you plan on keeping these loans past their initial fixed-rate period, it is important that you understand the histories of those indices and anticipated future direction.

SHORT-TERM I-O ARMS (Risk Tolerance: MEDIUM-HIGH)

Short-term I-O ARMS are the most heavily advertised Interest-Only product because they offer very low introductory starting rates with flexible multiple payment options. These are very enticing products but consumers must know much more about these loans compared to other, less sophisticated options.

These products feature rate changes as often as every 1 month, 6 months or 1 year. While some are tied to the LIBOR index mentioned earlier, many are tied to alternative indices including the MTA, COFI, COSI, CODI and others. It's very important to understand that each index has its own unique history, factors that move it, and anticipated future direction. Generally speaking, the lower and more stable the Index, the higher the Margins you’ll find on it.  The key is finding the right combination of these two factors.

These products adjust much sooner than Long-term ARMS so the rate is determined by adding the Index to the Margin by as soon as the 6th month, making the Index and Margin selection extremely important. Many of these loans feature a multiple payment option in which consumers can choose amongst 4 different monthly payment options:

Option 1 is based on 15 Year Amortization       =             Large Contribution to Principal
Option 2 is based on 30 Year Amortization       =             Small Contribution to Principal
Option 3 is based on the I-O payment              =             NO Contribution to Principal
Option 4 is based on Negative Amortization                    =               Negative Contribution to Principal

The Negative Amortization (NegAm) option allows you to pay a tiny Out-of-Pocket payment - in fact, not enough to cover even the minimum Interest-Only payment that is due. However, the difference must be accounted for and is therefore ADDED to the loan’s Principal Balance. That's right, with the NegAm option, you pay a tiny monthly payment but your outstanding mortgage balance actually RISES over time, rather than lowers or stays the same - a 200k loan may become 220k over time!

These loans are generally not preferred on Primary Residences(unless the Margin is extremely low) however they are ideal for Investors who want to maximize their cash flow on their rental properties.  Some Investors have properties with substantial equity and prefer a lower payment and more monthly cash flow versus having more equity.  In this case, the multiple payment option loans with the Negative Amortizing option is appropriate as it will allow the absolute lowest out-of-pocket monthly payments at the expense of their property’s existing equity and future appreciation.

HELOC-based ARMS (Risk Tolerance: INSANE)

A small but growing class of I-O products is HELOC-based. HELOC stands for Home Equity Line Of Credit and many of you are familiar with this product as a 2nd Mortgage. Now lenders are offering this product as a 1st Mortgage.

While most mortgage rates are tied to Bond market activity, HELOC-based products are the exception as they exactly track the Prime Rate that the Federal Reserve sets. With the Prime Rate recently floating for over a year at 4.0%, consumers were enticed by these extremely low rates but most didn't realize that these that these loans are in fact Adjustable Rate Mortgages which track the Federal Reserve exactly and as such, consumers should be aware of the following:

1. The Prime Rate has risen 11 times in a row to 7.00%.  A 3% rate change within 1 year on a large 1^st mortgage balance can double your payment and truly be devastating. 

2. The rates on these loans rise suddenly with no warning or anticipation. If the Fed raised the Prime Rate at the next Fed meeting, all HELOC-based mortgages would see a rate and payment change by the very next month whereas other Indices LAG the Fed.

HELOC-based 1^st mortgages pose the highest imaginable risk. Nonetheless, they are appropriate for a few.  Real Estate Investors use this Credit Line as a quick way to draw cash for rehab projects and the like.  These asset-rich Investors benefit from the quick draw ability, Interest-Only payments and low rate when compared to Private Money sources.  The general profile of the Investor who benefits from the HELOC-based 1^st mortgage: they have substantial equity in their Primary residence or own it outright and they desire drawing Funds quickly and often in order to fund other real estate-based rehab projects that are generating a higher return than the rate they are paying on the Line.