The pros and cons of interest-only and ARM option loans

by Natasha Nikulina11 Feb 2021

Interest-only loans and ARM options on long-term loans have been around for a while but does everyone understand them? Like all loans, they need to fit the investment strategy or they run the risk of putting the borrower in an unfavorable position and cause them to lose money. Not all loan applicants can see the bigger picture of these very specific loans and why they should consider them. Here we will discuss the benefits and downsides of these two loan options to help you understand where each makes the most sense.

First, let’s define both interest-only and ARM option loans. An interest-only loan is just that: monthly payments are made only toward the interest and not the principal. An ARM option on a long-term loan is where the borrower has a fixed rate for a specific length of time and then the rate will adjust when the allotted timeframe ends. Taking a 7/1 ARM as an example: the borrower will have a fixed rate for seven years (7/1 ARM), at which point the rate will adjust one time (7/1 ARM) before the rest of the loan term is completed.

Now let’s dive into the pros and cons of these loan types.

Interest-only loans

Pros:

The payments are made toward interest only every month and are smaller than principal and interest payments would be in a fully amortized loan. Borrowers do not need to worry about making larger payments and can focus on stabilizing their financial situation instead. Borrowers with variable incomes, reduced financial situations, or those who do not plan on keeping a property for long are potential candidates for considering an interest-only loan option.

Cons:

Even if a borrower qualifies for an interest-only option, they need to carefully consider how they will manage this loan option and prepare for larger payments in the future. Interest rates may be low now but may increase by the time the interest-only period ends and the borrower would be stuck with paying not just higher interest but, at that point, they would need to pay down the principal as well. Also, when a borrower is paying only interest each month, they are missing out on building equity for their property.

ARM options on a long-term loan

Pros:

The ARM option will have a lower rate and payments early on in the term compared to a standard, fixed-rate long-term loan. Borrowers who choose the ARM option can also take advantage of falling rates in the market without having to refinance their loan. This option may also be a more cost-effective way to own investment real estate if a borrower is planning on keeping the property short-term.

Cons:

Although the payments are smaller early on, they can rise significantly as the loan term progresses. Not only because the fixed-rate period will end but because the market conditions might swing the interest rate in an upward trend. ARM options may also be more difficult to understand for newer investors so the benefits are not clearly seen leaving the investor unaware of potentially beneficial possibilities for their investment strategy.

As you can see, both options have benefits and drawbacks depending on how they are used. Potential loan applicants need to be aware of what happens after they are approved for one of these loan types and they are left to manage the loan payments. Remind yourself that loan terms end and that the loan payment in the future may become unmanageable if the borrower is not prepared. Do your due diligence, research your options, and always speak with a loan officer to discuss what the loan will look like now and in the future. Reach out to RCN Capital if you have any questions or want a quote for a deal scenario that best fits your investment strategy.

About the Author

Natasha Nikulina, Business Development Coordinator, is committed to building and maintaining customer relationships, as well as educating potential clients on RCN Capital’s diverse product line. Joining the company in the summer of 2018, Natasha’s mission is to create open communication that benefits both the company and its clients. Her previous customer service experience will be used extensively at RCN Capital to assist clients with their needs. Natasha graduated from the University of Massachusetts Amherst, with an honors degree in Marketing.