How do 7/1 Interest-only ARM’s work?

With a 7/1 interest-only ARM the loan will carry a fixed rate for the initial 7 years of the loan. After that, the interest rate will adjust on an annual basis. For the first 7 years of the loan the borrower may make interest-only payment on the outstanding balance. At the end of 7 years the payments will amortize annually based on the remaining term of the loan.

For example, let’s say we could lock a loan today @ 6.00% on this program for a $300,000 loan. For the first 7 years the borrower would make an interest-only payment of $1,500 per month. At any time the borrower could make a payment above and beyond the interest-only payment which would be applied to principal. Because the loan carries an interest-only payment they could expect their payments to decrease upon paying down a portion of the principal.

After 7 years let’s assume the rate adjusts to 8.00% and the balance was still $300,000 (because the borrower elected not to pay any principal over the first 7 years). At that time the monthly payments would increase to $2,380 which reflects a 23 year amortization at 8.00%.

This loan can be a great program because for most home-buyers the 7 year fixed period offers plenty of interest-rate security while the interest-only payment provides plenty of cash-flow flexibility.