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Are Interest Only Mortgage Loans Still Available?

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For most homebuyers, the goal is to buy the ideal home while making the lowest monthly payments possible. Meeting this goal means navigating through a wide variety of mortgage loan variables, including the amount of the down payment, the current interest rates, and whether you want an adjustable-rate mortgage (ARM) or a fixed-rate mortgage (FRM). There is another variable that you may want to consider: whether to choose a fully amortized mortgage or an interest-only mortgage (IO).

The fully amortized mortgage

This is the one that most people are familiar with. Each monthly payment that you make to your lender both pays the interest and pays down the principle. The ratio changes as the loan ages. Initially, you are paying mostly interest. This is a protective device used by lenders to increase the odds that they will collect the profit portion of the deal as early as possible.

For a typical 30-year mortgage of $200,000 at 7% interest, you'll be making a monthly payment of $1,330. Of this amount, for your first payment the interest portion will be $1,166 and the principle will be only $164. As the years go by the ratio will change. By the first month of year 20, you will pay $713 in interest and $617 in principle. By the time you make your last payment after 30 years, you will pay $8 in interest and $1,322 in principle.

Over 30 years you will have paid total of $479,021, of which $279,021 will be interest. The loan has been amortized, which means that the principle has been paid down over time.

The interest-only mortgage

One way to reduce your monthly payments in the short term is to take out an interest-only loan. With an IO, during a set number of years (5 or 10) you pay only interest. At the end of the period, you pay both interest and principle. But here's the rub: because you are not paying down the principle during the IO period, at the end of the IO period your monthly payments will increase. This is because now you have to pay down your principle more quickly.

On a 30-year loan of $200,000 at 7% interest, let's say you agree to an IO period of five years. Your initial payments will be $1,166 per month, which is $164 lower than an amortized loan. You are saving money. But after five years your monthly payments will climb sharply, because you need to pay down the principle at a faster rate than if you had been paying a fully amortized loan. It makes sense - after 30 years the loan must be paid off, and now you have only 25 years to pay down the principle, not 30 years.

With your IO loan, after 30 years at 7% you would have paid a total of $494,067, of which $294,067 was interest.

Why choose an interest-only mortgage?

There are some good reasons for choosing an interest-only loan. You choose this loan because you are looking for short-term savings.

  • You can take the cash you save and invest it elsewhere at a favorable rate
  • You anticipate selling the property before the end of the IO period
  • You anticipate an increase in your personal income before the end of the IO period

Reasons to avoid an interest-only loan

  • You cannot predict the future. Your income may not rise in the next few years. You may not be able to sell the property at a profit before your monthly payments increase
  • You plan on owning the property over the long term
  • Because IO loan are considered by lenders to be more risky, most lenders charge a higher interest rate for an IO loan. You will pay much more in the long run

An interest-only mortgage loan can be a good strategy if you are disciplined and you have confidence in your ability to pay a higher monthly payment if and when it becomes necessary.