Introductory period

Many option ARMs have a 1-month or 3-month introductory period at the beginning of the loan. During this period, lenders use a lower interest rate to calculate your payments. For some I-O mortgage payment loans, this introductory period lasts 1, 3, or 5 years.

Interest rate adjustment period

Most payment-option ARMs have interest rates that adjust monthly after the introductory period. You could find that the interest you owe increases even though your minimum payment stays the same each month, adding to your negative amortization. Typical interest rate adjustment periods for an I-O mortgage are monthly, every 6 months, or once a year.

Payment adjustments

Most I-O payment mortgages and payment-option ARMs have payments that adjust once a year. In addition, most of the adjustments on payment-option ARMs are limited by a payment cap, usually 7.5%. Keep in mind that payment caps do not apply when your loan is recalculated at the normal recalculation period. Payment caps also do not apply if your balance grows beyond 110% or 125% of your original mortgage amount.

Recalculation period

With a payment-option ARM, your loan will be recalculated, or recast. The recalculation period is usually 5 years, but it can vary depending on the terms of your loan. When your loan is recalculated, the 7.5% payment cap does not apply, so you could see a large change in your monthly payment. After your loan is recalculated, you will still have the option to make a minimum payment. I-O loans are recalculated at the end of the option period (usually 3, 5, or 10 years); after that you will pay back both the principal and interest for the remaining term of the loan.

Important Terms

Adjustable-rate mortgage (ARM)

A mortgage that does not have a fixed 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.

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 refinancing a home. The actual expenses at closing may be somewhat different from the good faith estimate.


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.


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


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.


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

Links to other articles in this series:

  • Interest-Only Mortgages and Option-Payment ARM’s: Part 1
  • Interest-Only and Option ARM’s: Understanding Them- Part 2
  • Interest-Only and Option ARM’s: The Risks – Part 3
  • Interest-Only and Option ARM’s: The Advantages – Part 4
  • ______________________________________________

    Tony Gallegos – Serving the mortgage needs of Kennesaw, Marietta, Roswell, Smyrna, Powder Springs, Dallas, Acworth, Woodstock, Douglasville, Hiram, Austell and Atlanta. Subscribe to The Mortgage Cicerone:


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