Interest Only Mortgages

Interest Only mortgages main benefit is to keep mortgage payments low. Here is an example: The standard payment on a 6%, $100,000 loan is about $600; of that, $500 is interest, "saving" you just $100 per month. If lower payments are required, an adjustable mortgage provide for a lower rate which will ultimately lower payments.

Interest-only payment mortgages are rapidly becoming more popular. Freddie Mac and Fannie Mae both purchase these types of loans. Interest only mortgages have been around for some time.

The ideal use of the savings created by utitlizing interest only paymetns is to put it to better use such as consolidaitng high interest rate credit cards, more profitable investements, etc. For example, if you have an investment that pays 9% Interest annually and your mortgage rate is 5% you could argue that you are borrowing money at 5% interest for a 10% return. This is a viable use of interest-only payments.

Interest only motgages are offered on Adjustable Rate Mortgages (ARMs) or on fixed-rate mortgages (FRM) as well. These loan have become very popular and easy to qualify for. People with poor credit (subprime), puchasng home with zero down, and many other variations are all candidates for an interest only mortgage.

Expect a slightly higher interest rate. An interest-only mortgage will generally have about .125% higher interest rate than a similar fully-amortizing first mortgage.

Most interest only mortgages are only interest only for a fixed amount of years, then the mortgage pays principal and interest over the remainder of the loan term. The interest only period is generally between 2 years to 10 years long. A ten year interest only period is most common. Here is a tip: If you have made the interest only payments for the first 10 years of a 30 year loan, you will then have to pay the remainder of your loan off in only 20 years. This will lead to essentially a 20 year payment. At that time you could aways refinance or sell the home to avoid higher payments.

Where interest-only payment methods were formerly used for income leverage purposes -- using the same income stream to buy a home while accumulating other assets -- today's loans aren't being pitched only to well-to-do, sophisticated investors. While "cash- flow" purposes are still common, another audience with a different need has developed.

In the past several years, low mortgage rates, affordable housing initiatives, and innovative financing options have served to drive perhaps millions of potential homebuyers into the marketplace. That new demand has, in many areas, outstripped the supply of desirable homes, leading to what is termed a "seller's market," in which a lot of potential buyers compete for desirable properties. That demand, in turn, has allowed sellers to ask more for their homes -- and get it. Buyers without significant income or asset strength may have found themselves outbid and out of the running for a desirable property. Affordability, helped by falling interest rates, was now compromised by rising prices.

Interest-only payment options began to be offered to the masses not as a way to leverage their money, but rather as a way to borrow more money while not increasing the monthly payment. In the example above, instead of paying $600 on a regular 30-year fixed mortgage pay the interest only payment of $600 and qualify for a loan of $120,000 instead of $100,000. An interest only mortgage will allow a borrower to qualify for a larger home without a higher payment.

Most of our examples so far have dealt with interest-only payments overlaid on a fixed-rate mortgage. For ease of explanation, so will this one. However, we'll limit the interest-only payment period to five years, after which a fully-amortizing payment will be required.

In a fully-amortizing mortgage, your payments are based on the full term, typically 30 years. The $600 example above is based on a full 30-year term, with the "debt leveraged" borrowers spending all of that $600 on interest costs alone ($120,000 loan amount). After five years, the interest-only period expires and the borrower still owes $120,000 at 6%. However, that borrower no longer has 30 years over which to repay the outstanding balance; he has only 25 years. And since the payment is calculated on that shorter repayment term, the guaranteed result is a higher monthly payment: it jumps from $600 (interest-only) to $773 (now fully amortizing). That $173 jump represents a 29% increase in the monthly payment, so our borrowers are essentially betting that their income will have increased by at least that much. (By comparison, a fully-amortizing $120,000 loan at 6% would have had a fixed monthly payment of $719).

In our example, over the first five years, our borrowers would have spent $34,833 in interest. Over the remaining 25 years, total interest charges would be an additional $111,949 for a total of $146,782 in interest cost. If the borrowers had taken a fully- amortizing 30-year fixed-rate mortgage with the same specifications, their total interest cost would have been $139,006. In short, that interest-only payment scheme cost nearly an additional $8,000 over the life of the loan.

Most people don't usually remain in their mortgages for a full 30 years, so such an argument doesn't apply to everyone. here. However, a fully-amortizing loan as above, after five years, has a remaining balance of $8,300 less than the interest-only one does.

Market Risk I
Not repaying principal, and therefore not building any equity through debt retirement, means that an interest-only borrower is counting on market appreciation (price inflation) to help her own more of her home. Of course, this requires that prices increase while she holds the mortgage. Now, folks who follow the national realty markets are quick to point out that there hasn't been a broad decline in home prices since the Great Depression. However, you don't own the national realty market; you own a single home in a single neighborhood in a single town, and those followers will also concede that prices can and do increase and decrease regularly on a localized basis.

So what does this mean to the interest-only borrower? There is a danger in not reducing the balance. If prices should fail to increase during the interest-only period, and if the borrower should find a need to sell the home, he could potentially be on the hook for thousands of dollars in sales costs which would need to be paid out of whatever equity (in the form of the down payment) they started out with. According to the National Association of Realtors, typical down payments have fallen from 10% in 1990 to about 3% in 1999, so it's likely that at least some borrowers could be courting trouble here.

Market Risk II
The more extreme side of Market Risk I, of course, is that prices actually decline during the mortgage holding period. If our borrowers finds themselves in that situation, coupled with a low downpayment, they could easily find themselves "underwater" -- a descriptive term that means they'll sell the property for less than the remaining balance of the mortgage. In that unhappy case, the borrowers cannot sell without somehow coming up with what would likely be several thousand dollars to satisfy the mortgage balance as well as any sales charges (commissions, inspections, etc).

We noted before that payments made in the early years of a fully- amortizing are largely comprised of interest. However, in the examples above, we noted that a fully-amortizing loan was paid down by about $8,000 after five years. That's enough to cover the sales charges for a $130,000 home.

Interest Rate Risk
All the examples so far have been based on a mortgages with a fixed interest rate. Unfortunately, most of the interest-only loans being made today feature only short fixed interest periods, if any; some featuring adjustable rates which can change each month. As this is written, low interest rates are the order of the day, with some short-term rates at or near historic lows -- but if history teaches us nothing else, it's that low rates inevitably rise.

Above, we discussed term compression and its effect on payments, which causes them to rise above what they otherwise would be when the interest-only period ends. Now, magnify that compressed repayment term with a jump in interest rates, and you've got a recipe for a fiscal catastrophe.

Figure this: you, the interest-only borrower, have been happily making payments at $600 for the first five years of your (for now) fixed-rate loan. All the while, interest rates have been rising from their near-40 year lows to what could be considered "normal" -- about 7% -- and your monthly payment climbs over 40% to $848 per month. If you should find yourself in a period of considerably higher interest rates when the fixed-rate and interest-only period ends, your rate could climb to 9% or more -- in which case your monthly payment could jump to $1,000 per month, or more.

Also at the moment, liberal and flexible mortgage underwriting standards are allowing borrowers to borrow more money for the same income, because qualifying ratios have been greatly expanded. Theoretically, a borrower's budget might already be pretty stretched to the limit -- and that's before a nasty rate and payment hike.

The Good News
Interest-only payments do have a place in the world. In our opinion, at least, there are practical uses for borrowers to utilize a mortgage with interest-only payments -- but none of them involve leveraging themselves into a larger mortgage, particularly one with a variable interest rate.

If a borrower could afford either fully-amortizing or interest- only payments, under what circumstances might choosing the interest-only option provide a benefit?

Accumulating assets
If the interest-only payments are overlaid on a fixed-rate mortgage product with a fixed period of five years, a prudent borrower could invest the payment differential in a cash investment -- like a CD -- at an interest rate of perhaps 2% for the period. Over the five year fixed-rate period, that regular stream of deposits would grow to a balance of $7,566. At the beginning of the sixth year, should the mortgage rate increase to 7% (and with a payment term compression to 25 years, as described previously), the $173 additional due each month could be drawn from this "subsidy account." That way, the borrower would have no budget issues for a period of 44 months.

Of course, that's assuming just a 2% return over the period. If a borrower could locate a higher return over that period, that "subsidy" could last longer. However, it's very likely that after the sixth year, the mortgage rate would again change -- and a higher rate for the next year would certainly shorten the "subsidy" period.

Investing in the asset itself
Another worthwhile use for the "spare" cash that an interest-only loan provides would be to spruce up the home itself. The $100 per month (from our example) would allow the homeowner to invest up to $1,200 per year in improvement projects which can increase the value of the home. This may not buy a brand-new kitchen, but might be enough for a minor kitchen remodel, a new roof, bathroom upgrade, new energy-efficient windows, or vinyl siding, to name a few. (A pool sounds nice, but almost never pays for itself in an improved sales price.) Improving the value of the asset may mean a higher selling price later as well as some enjoyment now.

Money for college...
Financial planners and investment advisors will tell you that perhaps the most important component of an investment is the length of time over which it has to compound. This can be especially true if you have a young child you wish to send to college; the earlier that you can commit money to an investment plan, the more likely you will be able to reach or be closer to your goals. After the interest-only period ends, of course, you might not have additional money to commit to the savings plan, but the money already committed will have a longer compounding period.

...Money for retirement, too
Are you are an older homeowner, and seeing retirement on the horizon? Have your children grown and moved away, leaving you with a big home and no one to fill it... and you think you might sell it in just a few years? An interest-only payment scheme might work for you here, too. If you've been in your home for a while, your loan balance has shrunk; refinancing to a new mortgage, with a fresh 30-year term and interest-only payments, could free up a considerable amount of money each month to maximize your IRA contributions or other investments.

The Seasonal Income Factor
Not everyone in the workforce brings home a regular paycheck. Those with seasonal income, or who get a sizable portion of their income from bonuses or other sporadic payments, might also benefit from the lower payments that an interest-only scheme can provide. This can allow the borrower to make a smaller payment when cash is tight, then accelerate payments -- including principal -- when money is available. In this way, the borrower could end up with the best of both worlds.

Still interested in interest-only payments?
With their typically-lower-than-fixed interest rate, and coupled with interest-only payments, an ARM -- especially a short-term ARM -- could represent a way to have the lowest possible monthly payment and still be able to own your own home. However, all that flexibility comes with risks.

Some mortgage products, though, allow you to have your choice of payment plan, including interest-only, fully-amortizing or accelerated-amortizing. These so-called "option" or "pick-a-payment" ARMs are gaining in popularity, as they allow you to determine how best to apply your budget to your mortgage.

If you are already a candidate for an ARM, and if you have college, retirement or investment needs to take care of, you might consider adding interest-only payments to your ARM (or even taking an InterestFirst-style product) in order to more fully fund the other financial needs in your life. Maybe you've got a gambler's instincts, and want to bet that your home will be worth more in the future... or that you can invest the money better elsewhere than paying down your mortgage balance. As far as maximizing your tax deduction, remember that not only is that vast majority of your payment already comprised of interest, but that only a fraction of every dollar in interest you spend is tax deductible, anyway.

Of course, no one except you can say for sure what sort of mortgage options you'll need or want. However, you should be aware of the issues and drawbacks which surround those choices before you respond to marketing pitches.

Interest Only Mortgage: Bankrate Article

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