Types of Mortgages : Interest Only
(This was Written By Dian Hymer)
Many home buyers are turning to mortgages with interest-only payment schedules so they can afford to buy a more expensive home. These mortgages have lower monthly payments, which makes qualifying easier. But the lower payments don’t last forever, and interest-only loan aren’t for everyone.
Mortgages with an interest-only payment feature come in many varieties. Basically, they work like this. The borrower pays interest-only payments for the first five, 10 or 15 years. The monthly payments are lower than they would be with a fully amortized loan during this initial period. However, at the end of the interest-only payment period, the borrower still owes the entire amount borrowed.
With a fully amortized loan, part of each monthly payment pays back a portion of the principal (the amount borrowed). A fully amortized payment schedule pays back the loan in full during the term of the loan, which is usually 30 years. At the end of 30 years, you owe nothing.
Interest-only is a bit of a misnomer. You ultimately have to repay the amount you borrow, so you won’t make interest-only payments indefinitely. After the initial interest-only period, the principal is amortized over the remaining loan term. With a 30-year mortgage that has a 5-year interest-only payment plan, the principal will be amortized over the remaining 25 years of the loan. A shorter amortization period requires the borrower to make a higher monthly payment in order to repay the loan more quickly. This means an increase in the monthly payment starting with year six of the loan.
For example, if you were to borrow $250,000 at 6 percent, using a 30-year fixed-rate mortgage, your monthly payment would be $1,499. On the other hand, if you borrowed $250,000 at 6 percent, using a 30-year mortgage with a 5-year interest-only payment plan, your monthly payment initially would be $1,250. This saves you $249 per month or $2,987 a year. However, when you reach year six, your monthly payments will jump to $1,611, or $361 more per month. Hopefully, your income will have jumped accordingly to support the higher payments.
Mortgages with interest-only payment options may save you money in the short-run, but they actually cost more over the 30-year term of the loan. However, most borrowers repay their mortgages well before the end of the full 30-year loan term.
A mortgages with an interest-only payment schedule makes sense for some borrowers and is potentially risky for others. Borrowers who are counting on home-price appreciation to build equity could find themselves in a financial bind if home prices should drop and, for whatever reason, they’re forced to sell.
Not all interest-only mortgages have a fixed interest rate. Some have one rate for the initial interest-only period and a higher rate—with a much larger monthly payment—for the remainder of the loan term. Others resemble adjustable-rate mortgages (ARMs). A popular variety has a fixed rate with interest-only payments for the first five years. Then it converts to a 1-year ARM. You could face serious payment shock if interest rates rose significantly during the first five years.
Borrowers with sporadic incomes can benefit from interest-only mortgages. This is particularly the case if the mortgage is one that permits the borrower to pay more than interest-only. In this case, the borrower can pay interest-only during lean times and use bonuses or income spurts to pay down the principal.
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