Interest-only ARMs are particularly susceptible to payment shock due to which factor?

Interest-only adjustable-rate mortgages (ARMs) can indeed experience significant payment shock, particularly due to the recasting of the loan at the end of the interest-only period. In an interest-only ARM, borrowers initially pay only the interest on their loan for a specific term. Once this interest-only period expires, the loan transitions to a standard amortizing payment plan, where both principal and interest must be paid.

During the interest-only phase, payments are often low and manageable because borrowers are not reducing the principal amount owed. However, once the interest-only period concludes, the loan is recast, which means that the monthly payments are recalculated based on the remaining balance, the remaining loan term, and the interest rate, which might already be higher than the initial rate if rates have increased. This can lead to a sharp increase in the monthly payment amount, causing payment shock for the borrower.

This phenomenon emphasizes the importance of understanding the implications of an interest-only period, as borrowers may not be fully prepared for the jump in payments when they are suddenly required to begin paying off the principal alongside interest.