With an interest-only mortgage loan, you pay only the interest portion of each scheduled payment for a fixed term, often five to seven years.
After that, your payments increase, often substantially, to cover the accumulated unpaid principal plus the balance of the loan and the interest.
Before the higher payments begin, you may renegotiate your loan at the current interest rate or pay off the outstanding balance. However, it's possible that interest rates may have risen, in which case you will end up paying a higher rate on the entire unpaid principal.
If you have regularly invested the principal you weren't repaying and realized a return higher than the loan's interest rate, you could come out ahead. However, many borrowers don't invest the savings.
One risk with interest-only loans is that you may not be able to meet the higher payments once full repayment begins, especially if the interest-only payments themselves were a stretch.
Interest-Only Mortgage (Option)
An option attached to a mortgage, which allows the borrower to pay only the interest for some period.
A mortgage is “interest only” if the monthly mortgage payment does not include any repayment of principal. So long as the payment remains interest only, the loan balance remains unchanged.
For example, if a 30-year fixed-rate loan of $100,000 has an interest rate of 6.25%, the standard payment is $615.72. This payment is “fully amortizing,” meaning that, if it is continued and the rate does not change, the loan will pay off at maturity. The interest-only payment, however, is only $520.84. The $94.88 difference is principal repayment.
Interest-Only in the '20s and Now: If a loan is interest-only until maturity, the loan balance will be the same at maturity as it was at the outset. Back in the 1920s, loans of this type were the norm. Borrowers typically refinanced at term, which worked fine so long as the house didn't lose value and the borrower didn't lose his job.
But the depression of the '30s caused a large proportion of these loans to go into foreclosure. Lenders stopped writing them and switched to fully amortizing loans.
When interest-only loans were revived in this century, most were interest-only for a specified period, usually five to 10 years. At the end of that period, the payment was raised to the fully amortizing level.
Purpose of Interest-Only (1): One purpose is to increase affordability by reducing mortgage payments in the early years. In the example of a 30-year fixed-rate loan of $100,000 at 6.25%, referred to above, the interest-only payment is $94.88 less than the fully amortizing payment of $615.72.
The price of the lower payment during the interest-only period, however, is a higher payment later. If the interest only period on the loan described above is five years, then the fully amortizing payment starting in month 61 would be $659.67. In order to reduce the payment by $94.88 for the first five years, the borrower would pay an additional $43.95 for the next 25.
The longer the interest-only period, the larger the new payment will be when the interest-only period ends. If the same loan is inter-
est-only for 10 years, the fully amortizing payment beginning in month 121 is $730.93. In order to reduce the payment by $94.88 for 10 years, the borrower must pay an additional $115.21 for the next 20.
Purpose of Interest-Only (2): Another purpose of interest-only is to maximize investment leverage. A borrower earning 12% on investments wants to borrow as much at 6.25% as possible. Why pay down the mortgage to earn 6.25% when you can invest it to earn 12%?
That seemed like a plausible policy during the late '90s when stock market returns were extremely high. In the more sober environment of 2002-2003, it didn't make sense for most borrowers. With the stock market in the tank and interest rates very low, mortgage loan repayment was the best investment available to most homeowners.
Purpose of Interest-Only (3):Borrowers who have other debt at high interest rates might rationally select an interest-only option on their first mortgage so they can accelerate repayment of the more costly debt. If the rate is 5% on the first mortgage and 8% on the second, it makes sense to allocate as much as possible to repayment of the second.
Interest-Only ARMs: The interest-only option on ARMs presents spcial problems. If the interest rate on an ARM increases, the payment increase is substantially larger if the payment is interest-only than if it is fully amortizing.
Consider, for example, an ARM with an interest-only payment option for 10 years and an initial rate of 4%, which resets every six months. If the rate ratchets up to a maximum of 10% in month 19, the interest-only payment would increase by 150%. A fully amortizing payment, in contrast, would increase by only 82%.
Misperceptions: I have been dumbfounded by the claims about interest-only loans reported to me by mortgage shoppers. Whether the claims originate with loan officers or, as one defensive loan officer suggested to me, they arise in the overactive imagination of shoppers who still believe in the tooth fairy, I can't say for sure. Probably it is some combination of the two. All I know for sure is that misperceptions abound. Here are three common ones.
It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.
Suppose a borrower takes a mortgage with an interest-only option, but decides to make the fully amortizing payment instead.
Then the loan will amortize just as it would have if the interest-only option had not been attached. Whether the mortgage did nor did not have the option will affect the way it amortizes not a whit.
An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.
The notion that interest-only loans have lower rates arises from comparisons of apples versus oranges. Adjustable rate mortgages
(ARMs) with an interest-only option have lower rates than fixed-rate mortgages (FRMs) without an option. But an ARM with the option does not have a lower rate than the identical ARM without it.
Since the interest-only option is available on both FRMs and ARMs, it is pointless to be sucked into an ARM because of that feature.
On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. It is not. This is the most dangerous misperception of all because it can induce borrowers to take ARMs that don't meet their needs.
The interest-only period is the period during which you are allowed to pay interest only. The period for which the initial rate holds
is a different matter altogether. On an ARM with a very low rate, the interest-only period is always longer than the initial rate period.
A common ARM in 2003 had an interest-only option for 10 years, but the very low initial rate held only for six months. Numerous borrowers who thought the rate was safe for 10 years face a rude awakening. My impression is that loan officers didn't misinform them, but they didn't bother to correct them either.