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What are interest-extra loans?

A variation of the interest-only loan is the interest-extra loan. This type of loan can act as a principal reduction loan while reducing your payment. With an interest-extra loan, you pay a fixed amount each month on the principal.

Example: You have a $100,000 loan, with your first payment of $1,000 allocated $900 to interest and $100 to principal. Since you reduced your principal by $100, you now owe $99,900. Your second payment would be $100 toward principal and slightly less than $900 in interest, since you now owe $99,900 instead of $100,000. The payment would continue to fall, since each monthly payment would be based on what you owe, not what you originally borrowed.

The loan works best if you pay a large amount per month toward the principal. Since you are reducing your principal amount quickly, you are correspondingly reducing your interest quickly — and thus, your total payment quickly.

This type of loan is ideal for borrowers with good present income that is expected to fall. A working couple that expects one or both of them to retire in ten years would be good candidates. By the time they face lower incomes, their mortgage payment would be substantially lower. They would not have to refinance in order to lower the payment. Unfortunately, this type of loan is not offered by your average lender.

This loan is simply a variation of the commonly used interest- only loan. The difference is that with an interest-only loan, the borrower can only reduce the principal by voluntary payments in excess of the required payment. The interest-extra loan requires a payment higher than interest-only, forcing the borrower to reduce the principal. You may be able to create an interest-extra loan by asking your lender to take an additional amount above interest only as an automatic withdrawal from your checking or savings account if your loan is set up for automatic withdrawals. This will reduce the interest amount each month. Your best chance to do this is with a bank or credit union.

If your lender cannot or will not do this, you will have to voluntarily pay the additional amount with each payment.

What are balloon payment mortgages?

A balloon payment is a lump-sum payment at the end of the term of a loan when the monthly payments over the term are not sufficient to amortize the loan. For example, at the end of an interest-only loan, the remaining balance must be made with a lump sum, or balloon payment.

There are variations that fall between interest-only and full amortization loans. These are loans that base the payment on a term different from the actual term. A typical one is a 30/5 loan. This means that the payment is based on thirty years, but the loan must be repaid in five years. The required payments are not enough to pay off the loan, creating the balloon payment at the end of the five-year term.

The obvious question is, what happens at the end of the five-year term? You can, of course, pay the balloon by refinancing. You are betting that rates will not rise too much in that five-year period.

You can also sell the property. If your plan in getting this loan is to sell before the balloon is due, that is a good reason. The interest rate may be lower on the balloon mortgage compared to an adjustable rate mortgage.

Today's balloon mortgages will usually have a refinance clause. They will typically guarantee that the lender will either extend the term of the existing loan or give the borrower a new loan. There are usually some fees involved in the modification and always in the refinance. In addition, there are generally two requirements.

1. First, the borrower must not be delinquent on the payments. This just makes sense — if you cannot pay your existing loan, why would the lender want to extend it or give you a new loan?

2. Second is the interest rate. You are going to get the extension or new loan at the prevailing rates five years after the original loan. You can see the problem if rates rise dramatically. Unless the lender will guarantee a limit on the interest rate for the modification or refinance, you are at the mercy of the market.

An alternative is an adjustable rate mortgage with a low interest rate for the first five years, (see Chapter 9.) It will probably cost you more than the balloon mortgage, but it will have a limit on the amount that the interest rate can increase after the initial five-year period.

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