Interest Only Loans

Understanding Interest Only Loans

Normally an Interest Only loan is an adjustable-rate mortgage with a 30-year term, but with a typical starting period of five or seven years during which the borrower(s) are required to pay only the interest that the principal is accruing. Not all interest- only loans have a fixed rate during the interest-only period. On most interest-only loans the interest rate adjusts annually. At the end of the interest-only period, payments will rise, as the principal is amortized over the remaining term of the loan.

For example, a $500,000 loan at 5.25% during a seven-year interest only period, the monthly payment is $2,188. If you used the same loan amount and 5.35% interest rate on a fixed-rate 30 year mortgage, the monthly payment for the full term of the loan is $2,761.

Advantages of an Interest Only Loan

  1. Lower monthly costs than almost any principle-and-interest mortgage.
  2. It is a good loan choice for investors desiring to buy properties in a high appreciation market environment that want to buy and resell before the interest-only period ends. (Note: It can be high risk loan if the housing market in that area should suddenly change for the worst and the borrower can not sell the home prior to taking a loss.)
  3. A good choice for people who want to reserve some cash.
  4. Allows borrowers to qualify for bigger mortgages (lenders approve the loan based on the borrower’s ability to afford the monthly payment). So if you can afford to pay $2,000 a month that might get you a traditional fixed-rate mortgage of $335,000 at 6%, or an interest-only mortgage of $400,000 at 6%.
  5. Borrowers can pay up to 20 percent of their principle annually without penalty. That helps those borrowers whose income fluctuates during the year. Example: Individuals paid on commission.
  6. Potentially, a good choice for buyers who plan to sell or refinance before the interest-only period ends and their payments go up sharply.


Disadvantages

  1. Monthly payments will rise dramatically after the interest-only period ends and will depend on prevailing interest rates. If you are unable to refinance the loan and don’t plan to sell the home, the resulting payments might not be more than the buyer can afford to pay.
  2. Poor choice for borrowers who want to know exactly what their payments will be after the initial interest-only period ends. Who can predict where rates will be in five years?
  3. Poor choice for borrowers whose goal is to gain equity by paying down their principle.
  4. Requires very good credit to qualify

While the Interest Only Loan is one of the “hot new loans” being advertised by many lenders, we do not recommend this for people on a fixed income or anyone moving into their retirement years that can not afford to take a financial risk later in life.

 

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