Owning a home is part of the American dream. But high home prices may make the dream seem out of reach. To make monthly mortgage payments more affordable, many lenders offer home loans that allow you to (1) pay only the interest on the loan during the first few years of the loan term or (2) make only a specified minimum payment that could be less than the monthly interest on the loan.

Whether you are buying a house or refinancing your mortgage, this information can help you decide if an interest-only mortgage payment (an I-O mortgage)--or an adjustable-rate mortgage (ARM) with the option to make a minimum payment (a payment-option ARM)--is right for you. Lenders have a variety of names for these loans, but keep in mind that with I-O mortgages and payment-option ARMs, you could face

• "payment shock." Your payments may go up a lot--as much as double or triple--after the interest-only period or when the payments adjust.

In addition, with payment-option ARMs you could face

• negative amortization. Your payments may not cover all of the interest owed. The unpaid interest is added to your mortgage balance so that you owe more on your mortgage than you originally borrowed.

Be sure you understand the loan terms and the risks you face. And be realistic about whether you can handle future payment increases. If you're not comfortable with these risks, ask about another loan product.

View Interest-Only Mortgage Payments and Payment-Option ARMs: Are They for You?

What is an I-O mortgage payment?

Most mortgages that offer an I-O payment plan have adjustable interest rates, which means that the interest rate and monthly payment will change over the term of the loan. The changes may be as often as once a month or as seldom as every 3 to 5 years, depending on the terms of your loan. For example, a 5/1 ARM has a fixed interest rate for the first 5 years; after that, the rate can change once a year (the "1" in 5/1) during the rest of the loan. More information on ARMs is available in the Federal Reserve Board's Consumer Handbook on Adjustable Rate Mortgages.

The I-O payment period is typically between 3 and 10 years. After that, your monthly payment will increase--even if interest rates stay the same--because you must pay back the principal as well as the interest. For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest for 5 years and then both principal and interest over the next 25 years. Because you begin to pay back the principal, your payments increase after year 5.

What is a payment-option ARM?

A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include

• a traditional payment of principal and interest (which reduces the amount you owe on your mortgage). These payments may be based on a set loan term, such as a 15-, 30-, or 40-year payment schedule.
• an interest-only payment (which does not change the amount you owe on your mortgage).
• a minimum (or limited) payment (which may be less than the amount of interest due that month and may not pay down any principal). If you choose this option, the amount of any interest you do not pay will be added to the principal of the loan, increasing the amount you owe and increasing the interest you will pay.

Interest rates. The interest rate on a payment-option ARM is typically very low for the first 1 to 3 months (2%, for example). After that, the rate usually rises to a rate closer to that of other mortgage loans. Your monthly payments during the first year are based on the initial low rate, meaning that if you only make the minimum payment, it may not cover the interest due. The unpaid interest is added to the amount you owe on the mortgage, resulting in a highter balance. This is known as negative amortization. Also, as interest rates go up, your payments are likely to go up.

Payment changes. Many payment-option ARMs limit, or cap, the amount the monthly minimum payment may increase from year to year. For example, if your loan has a payment cap of 7.5%, your monthly payment won't increase more than 7.5% from one year to the next (for example, from $1,000 to $1,075), even if interest rates rise more than 7.5%. Any interest you don't pay because of the payment cap will be added to the balance of your loan.

Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term recast) based on the remaining term of the loan. If you have a 30-year loan and you are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your payments could go up a lot.

Ending the option payments. Lenders end the option payments if the amount of principal you owe grows beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made minimum payments on your $180,000 mortgage and had negative amortization. If the balance grew to $225,000 (125% of $180,000), the option payments would end. Your loan would be recalculated and you would pay back principal and interest based on the remaining term of your loan. It is likely that your payments would go up significantly.

Download Interest-Only Mortgage Payments and Payment-Option ARMs: Are They for You?

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Office of Thrift Supervision

Glossary:

Adjustable-rate mortgage (ARM)
A mortgage that does not have a fi xed interest rate. The rate changes during the life of the loan in line with movements in an index rate, such as the rate for Treasury securities or the Cost of Funds Index.

Amortizing loan
Monthly payments are large enough to pay the interest and reduce the principal on your mortgage.

Cap, interest rate
A limit on the amount your interest rate can increase. Interest caps come in two versions:

• periodic caps, which limit the interest-rate increase from one adjustment period to the next, and
• overall caps, which limit the interest-rate increase over the life of the loan. By law, virtually all ARMs must have an
  overall cap.

Cap, payment
A limit on how much the monthly payment may change, either each time the payment changes or during the life of the mortgage. Payment caps do not limit the amount of interest the lender is earning, so they may lead to negative amortization.

Equity
The difference between the fair market value of the home and the outstanding mortgage balance.

Good faith estimate
The Real Estate Settlement Procedures Act (RESPA) requires your mortgage lender to give you a good faith estimate of all your closing costs within 3 business days of submitting your application for a loan, whether you are purchasing or refi nancing a home. The actual expenses at closing may be somewhat different from the good faith estimate.

Index
The index is the measure of interest-rate changes that the lender uses to decide how much the interest rate on an ARM will change over time. No one can be sure when an index rate will go up or down. Some index rates tend to be higher than others, and some change more often. You should ask your lender how the index for any ARM you are considering has changed in recent years, and where the index is reported.

Interest
The price paid for borrowing money, usually given in percentages and as an annual rate.

Margin
The number of percentage points the lender adds to the index rate to calculate the ARM interest rate at each adjustment.

Negative amortization
Occurs when the monthly payments do not cover all the interest owed. The interest that is not paid in the monthly payment is added to the loan balance. This means that even after making many payments, you could owe more than you did at the beginning of the loan.

Prepayment penalty
Extra fees that may be due if you pay off the loan early by refinancing your home. These fees may make it too expensive to get out of the loan. If your loan includes a prepayment penalty, be aware of the penalty you would have to pay. Ask the lender if you can get a loan without a prepayment penalty, and what that loan would cost.

Principal
The amount of money borrowed or the amount still owed on a loan.

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