Interest Only Mortgage

As a borrower prepares to buy a home, they will need to decide what type of mortgage is appropriate.

An interest-only mortgage may be suit the needs of the borrower if:

• The borrower intends to stay in the home for 7-10 years or less
• The borrower is comfortable with a monthly payment that will change
• The borrower has income that varies (e.g., commissions, bonuses, etc.)
• The borrower has other investments besides the home into which he or she wants to invest money each month

The following article discusses the IO option: what it is, how it works, and the pros and cons, so that a prospective homeowner can decide if this option is appropriate.

As the payment comparison table in this article shows, the interest-only option allows borrowers to pay, for a designated period (usually 5 to 10 years), only the interest on their loan. They can pay more if they choose, but are obligated to pay only the interest.

During that time, if the borrower pays only the interest, the loan does not amortize (in other words, the principal loan balance remains unchanged). At the end of the interest-only period, the payment is raised to the fully-amortizing level for the remainder of the loan, so that the borrower can begin paying the principal in addition to the interest.

Choosing a mortgage with an IO option depends on the borrower's financial needs and goals.

As one prepares to purchase a new home, the borrower needs to decide how to finance that purchase. Specifically, how does the mortgage fit into their overall financial plan?

For example, as a borrower chooses a mortgage, they need to consider such questions as:

• How long do they intend to stay in this home?
• Do they want an interest rate and/or monthly payment that will not change over the life of the loan?
• Are they comfortable with an interest rate and/or monthly payment that periodically may change over the life of the loan? Moreover, if so, will they have the income to cover potential mortgage payment increases?
• What other debts will they have besides their mortgage?
• What other investments do they wish to make, besides the one they are making on a home?

The borrower may wish to consider an interest-only mortgage if they:

• Intend to stay in the home for 7-10 years or less;
• Are comfortable with a monthly payment that will change;
• Have income that varies (e.g., commissions, bonuses, etc.)
• Have other investments besides their home into which they want to put money every month...

This article focuses on IOs, and enables a potential homeowner to decide if an IO meets their financial needs and goals, by answering the following questions about it:

• What is it?
• How does it work?
• What are the pros and cons?

What is It?

First a bit of name clarification is in order.

Strictly speaking, there's no such thing as an interest-only mortgage. Rather, interest-only is a payment option that can accompany a fixed, ARM or hybrid mortgage.

As its name implies, the interest-only option allows borrowers to pay, for a designated period (usually 5 to 10 years), only the interest on their loan. They can pay more if they want to, but they are obligated to pay only the interest. During that time, if the borrower pays only the interest, the loan does not amortize (in other words, the principal loan balance remains unchanged).

At the end of the interest-only period, the payment is raised to the fully-amortizing level for the remainder of the loan, so that the borrower can begin paying the principal in addition to the interest.

The interest-only option is nothing new. In fact, during the 1920s it was commonplace. At the end of the interest-only term, homeowners typically would refinance their homes if they weren't planning to sell them. This deferment of paying principal worked very well as long as homes appreciated and the borrowers didn't lose their jobs.

However, when the Great Depression hit in 1929, the worst happened: homes depreciated AND borrowers lost their jobs. As a result, many could no longer meet their mortgage debt. Foreclosures happened in record numbers, and lenders stopped offering the interest-only option.

Interest-only didn't really make a comeback until 2001. Initially, that comeback occurred primarily in the jumbo loan market (note: jumbo loans are "nonconforming" mortgages whose amounts are higher than $359,650 for a single-family home).

Since 2002 however, the interest-only option has also made a comeback into the conforming loan market as well. There are a few reasons for this:

• Borrowers are looking for ways to offset ever-rising home prices, and the interest-only option seen as a tool to accomplish this goal. There are two facets to this. First, with the interest-only option, borrowers can qualify for a larger mortgage because the qualification is based on their ability to pay the interest-only monthly payment, not the fully-amortizing monthly payment. Additionally, the interest-only monthly payment is a smaller "nut to crack" each month, allowing borrowers to afford a higher-priced home than they would without the IO option (at least while the interest-only period lasts).
• These days, borrowers typically won't keep the same mortgage for more than 7-10 years. The prevailing trend today is to sell or refinance within that time frame. Hence, borrowers who find the interest-only option attractive usually plan to sell or refinance before the interest-only period ends. They figure that they can save a good deal of money during the interest-only period, and they do not plan to keep the loan long enough to suffer the "payment shock" that can occurs when that period ends.
• A growing number of borrowers these days are not concerned about building equity by paying down or paying off their mortgage. Instead, they prefer to let the market take care of that for them through future appreciation of their property's value. Hence the thinking goes, "why should I worry about spending a lot of money building equity when I am going to make a big profit on this house once I sell it?"
• A growing number of today's borrowers do not consider their home to be their primary investment. Instead, it is one of many. Therefore, rather than tying up money in a big monthly principal and interest payment, these borrowers prefer to pay the minimum for their home, while investing the difference in other vehicles (e.g. stocks, bonds, their 401(k), etc.).

How does it work?

Interest-only is an option that can come with a fixed, ARM or hybrid mortgage.

The interest-only option works in basically the same manner, regardless of loan type. For a set period, usually for the first 5 or 10 years, the borrower is only obligated to pay the interest every month. They can pay the principal if they wish to, but the interest is the only obligation. (Note: if the borrower has an ARM product, the monthly payment during the interest-only period goes up or down as interest rates go up and down.)

At the end of the interest-only period, the monthly payment will adjust to be "fully amortizing" for the remainder of the life of the loan. In other words, at this point the monthly payment will increase to reflect not only interest, but the amortization of principal as well.

The following matrix illustrates how this would work with a 30-year fixed-rate mortgage of $250,000 at 6%. It compares what the monthly payments are with a 5-year interest-only option, versus without that option.

With the IO option, the borrower pays just the interest on the $250,000 loan - $1,250.00 per month - for the first five years. Therefore, at the end of those five years, the borrower does not have a reduced principal balance- the principal balance is still $250,000.

In order to make the loan amortize for the remaining 25 years, the lender adjusts the monthly payment to $1,610.75. That is the fully amortized principal and interest payment on a $250,000 loan at 6% interest for 25 years.

Given the above illustration, one might ask, "why would I want a mortgage with an IO option?"

The interest-only option may be right if the borrower:

• Plans to sell or refinance the home before the interest-only period ends
• Is not as concerned with building equity now via paying down the mortgage debt as they are with building equity in the future through appreciation
• Plans to use the money they would save on the interest-only payment for other investments

What are the pros and cons?

The interest-only option is an appropriate choice if a borrower prefers to make minimum monthly payments on the home in order to free up cash for other investments, and/or if the borrower does not plan to keep the loan beyond the interest-only period.