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Interest-Only Mortgages

Interest-only mortgages became very popular in 2005, when over 50 percent of new mortgages included an interest-only feature. For the first five, ten, or fifteen years, payments on an interest-only mortgage do not include principal repayments. The loan does not begin to amortize until the interest-only period is complete. Figure 4.10 shows the amortization of a $100,000, 8-percent fixed-rate loan with a ten-year interest – only feature. For the first ten years, the loan balance remains at $100,000, and then the payment is increased and the loan begins to amortize. After 20 years the balance is still $68,900, but like a traditional 30-year fixed-rate mortgage, it is fully paid off at the end of the loan.

An interest-only feature can be appended to a tradition fixed- rate mortgage or to an adjustable-rate mortgage (ARM). In both cases, the borrower is only required to pay interest and not principal repayments during the interest-only period. With an ARM, the required payment goes up and down just like other ARMs. With interest-only ARMs, there may be differences in how rate and payment caps are applied at the end of the interest-only period. Have your loan officer explain exactly what happens at the end of the interest-only period if you choose an interest-only ARM.

As with any mortgage, fixed rate or adjustable rate, you can make “extra payments” to reduce the principal balance. With a traditional fixed-rate mortgage, making an extra payment does not change the amount that you are required to pay on future payments. Both rate and payment are fixed for the life of the loan. With an interest-only mortgage, if you make an extra payment to reduce

FIGURE 4.10 Amortization Chart of a Sample Interest-Only Mortgage

Amortization Chart of a Sample Interest-Only Mortgage

your principal balance, the required interest payments are less in subsequent months.

At the end of the interest-only period, your monthly payment increases to begin amortizing your loan. In the previous example, the loan payment would increase from $667 per month to $836. If you made extra payments during the interest-only period, your new payment is less.

Advantages. The main advantage of the interest-only mortgage is the lower initial monthly payment. For a $100,000 mortgage at 8 percent, the monthly payment is $734. For an interest-only mortgage, the starting monthly payment is $667. Because the starting payment is lower, the income needed to qualify is also lower, in this example, by about 8 percent. (See Figure 4.11.)

Disadvantages. The primary disadvantage to the interest-only mortgage is that it costs a bit more than the traditional mortgage. Lenders charge from one half to one point more for an interest- only feature. This has the effect of raising your interest rate by about 0.15 percent. Another disadvantage associated with the interest-only mortgage is a low equity return if you sell your house before repaying any principal. The only equity you earn on the

FIGURE 4.11 Comparison of a Traditional and an Interest-Only Mortgage: Approximate Income Required to Qualify for a $100,000 Loan

Comparison of a Traditional and an Interest-Only Mortgage: Approximate Income Required to Qualify for a $100,000 Loan

property is from appreciation you may incur while owning the home.

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