Thanks for visiting Bills.com. The loan you are describing is a type of Adjustable Rate Mortgage ("ARM") frequently called a “hybrid ARM” because it combines aspects of both the classic fixed rate and adjustable rate mortgages.
The interest rate on a hybrid ARM is "fixed" for the first few years of the mortgage. After the fixed rate period ends, the interest rate begins to adjust at a defined interval, just like a regular ARM.
Different types of hybrid loans are named based on the number of years for which the interest rate is fixed, represented by the first number, and how often the rate adjusts thereafter, represented by the second number. For example, in a 5/1 ARM, the 5 means that the interest rate will not change for the first five years of the loan. The 1 (meaning 1 year) tells how often the rate will adjust after five year fixed rate ends. So in a 5/1 ARM, after the five year fixed rate period ends, you can expect your rate to adjust once annually.
Be careful, though, because this numbering system is not always consistent. For example, a 3/6 ARM means that after three years, the loan will adjust every six months, not every six years.
With hybrid ARMs, an interest only (or "IO") option usually means that during the fixed rate period of your loan, your required monthly payments will only cover the monthly interest on the loan. However, after the fixed rate period ends, you will be required to pay a normal “interest + principal” payment. This change in the payment requirements, combined with the fact that your interest rate will likely increase due to the scheduled adjustments, means that your monthly mortgage payment may increase significantly. This can be source of significant "payment shock" which means that your monthly payment could skyrocket after the teaser period expires (5 years in your case).
Interest only hybrid ARMs may work for borrowers expecting significant income growth during the fixed rate portion of their loan. However, many borrowers take this type of mortgage because of the initial low monthly payments, but they are unprepared when their payments drastically increase. When this happens, many people are either forced to sell their homes, sometimes at a loss, or face foreclosure because they cannot afford their mortgage payments.
Before agreeing to any mortgage loan, make sure you discuss the terms in detail with the lender or broker. Also, make sure that you carefully read the mortgage agreement to verify that the terms outlined in the contract match the terms that you and the lender discussed. The last thing you want is to be stuck in a mortgage which you cannot afford due to a misunderstanding of the terms of the loan.
If you are buying a new home, I encourage you to explore the Bills.com Home Purchase page for more information about buying and financing a home.
I would also strongly encourage you to compare rates and offers from multiple lenders. You can apply with Bills approved lender network, and see if you can get a better deal!
I hope this information helps you Find. Learn. Save!