My prior post was an introduction to Adjustable-Rate Mortgages or ARMs. This post focuses on a subset of ARMs, called interest-only ARMs. As the name implies, this type of ARM requires interest-only payments for an initial set period of time, after which monthly loan payments will include principle repayment. Interest-only ARMs are typically “portfolio loans.” This means that the lender cannot package and sell them to mortgage giants Fannie Mae or Freddie Mac (we call these “conventional mortgages”). Instead, the lender holds the closed loans in their own portfolio. That means three key things:
- Each loan poses a greater risk to the lender, so the underwriting criteria for each loan is typically more stringent than for a conventional loan.
- Each lender can establish their own unique underwriting criteria, so the requirements will vary from lender to lender. In this post I will cover only the criteria specific to Dunwoody Mortgage customers who seek an interest-only ARM. Other lenders will have different requirements.
- Since each lender uses its own guidelines, the underwriting criteria can change much faster (for better or for worse) than for a conventional loan.
Interest-only ARMs available to Dunwoody Mortgage customers fully amortize over 30 years and have a 10-year interest-only period. That means that borrowers pay only interest – no principal – when they make only the required monthly payment for the first 10 years after closing. Once the interest-only period ends, if the borrower continues making only the required monthly payments, the loan principle will be amortized over the final 20 years of the loan term. And remember that the interest rate adjusts, so it can increase and decrease over the loan’s term.
The more stringent underwriting criteria include:
- Minimum down payment is 25%. Qualified borrowers can obtain a conventional fixed mortgage with a 5% (sometimes even 3% if they meet certain criteria) down payment.
- A minimum of 18 months of reserves (and sometimes 24 months) are required. This means that after closing, the borrower has enough remaining cash (as documented with account statements) to make eighteen months of mortgage payments. When purchasing a primary residence, conventional loans usually do not require reserves.
- From a debt-to-income ratio perspective, the borrower must qualify using the fully amortizing payment beginning in year 10 and using the fully-indexed interest rate. Qualifying using the initial interest-only payments will not suffice.
- First time homebuyers are not permitted.
Ultimately an interest-only ARM is a good tool for a specific type of home buyer. In most cases, the interest-only ARM borrower is looking for shorter-term (most likely less than 5 years and almost always less than 10 years) financing with a goal of minimizing payments during that period. One possible scenario is a parent of a college-aged student who wants to buy a home near the college and rent it to their student and his / her friends, but then sell the property when the child graduates from school. During that time, they want to minimize their monthly payments, so avoiding principal payments is helpful. It would really help when using this type of financing if the home is an area where property values are rising relatively quickly.
Considering a home purchase in Georgia and wondering if an interest-only ARM is right for you? Give me a call to discuss loan options and we can review the pros and cons of ARMs vs fixed-rate mortgages. I’ll help you navigate all the details and win you a competitive interest rate on your new mortgage.
