DEFINITION of 'Interest-Only ARM'

An adjustable-rate mortgage (ARM) with an initial interest-only payment period. During the interest-only period, only the calculated interest must be paid; no principal must be repaid. The length of the interest-only period varies with each mortgage type. After the interest-only period, the mortgage must amortize so that the mortgage will be paid off by the end of its original term. This means that monthly payments must increase substantially after the initial interest-only period lapses.

BREAKING DOWN 'Interest-Only ARM'

Interest-only ARMs carry a great deal of payment-shock risk. Not only do the payments have the potential to increase because of an increasing fully indexed interest rate, but the expiration of the interest-only payment means that payments will increase when it becomes a fully amortizing payment. Additionally, because the mortgage's principal balance is not reduced during the interest-only period, the rate at which home equity increases, or decreases, is entirely dependent upon home-price appreciation. Most borrowers intend to refinance an interest-only ARM before the interest-only period ends, however a reduction in home equity can make this difficult.

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