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What is an Interest-only Mortgage
An "Interest Only" Mortgage loan is a very popular alternative to traditional fixed rates.
With an interest-only mortgage loan, you pay only the interest
on the mortgage in monthly payments for a fixed term.
After the end of that term, usually five to seven years, you either refinance, pay the balance in a lump sum,
or start paying off the principal, in which case the payments jump skyward.
Who can Benefit from an Interest-only Mortgage
An interest-only mortgage might be a good fit for:
someone whose income is mostly in the form of infrequent commissions or bonuses;
someone who expects to earn a lot more in a few years;
someone who truly will invest the savings on the difference between an interest-only mortgage and an amortizing mortgage, and who is confident that the investments will make money.
Interest-only mortgages are not recommended to regular wage earners who take out moderate-size home loans and don't have a strategy for investing the savings.
What Hazards Should You Watch Out For an Interest-only Mortgage?
The major hazard is being deceived into accepting an interest-only mortgage that does not meet any of the suitability tests described above. The deceptions are about alleged desirable features of IOs that don’t in fact exist.
Borrowers can immunize themselves against most deceptions by remembering one critical fact. If two mortgages are identical except that only one has an interest-only option, lenders view that one as riskier.
The reason is that, after any period has elapsed, the loan with the IO option will have a larger balance.
1: An interest-only loan carries a lower interest rate. Lenders usually charge a higher rate for an identical loan with an interest-only option, for reasons indicated above. I have never seen a price sheet in which a lender quotes a lower rate on an identical loan with an IO option, though I am told it happens; this is not a perfect market.
1: Most interest-only loans are adjustable rate mortgages (ARMs), and ARMs have lower rates than fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates than FRMs because they are ARMs, not because they are IO.
2: An interest-only loan allows the borrower to avoid paying for mortgage insurance. Since loans with an IO option are riskier to the lender, the option cannot cause the disappearance of mortgage insurance.
Any IO loans with down payments less than 20% that don’t carry mortgage insurance from a mortgage insurance company are being insured by the lender. The borrower is paying the premium in the interest rate rather than as an insurance premium.
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3: On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. It may or may not be. The interest-only period is the period during which you are allowed to pay interest only, usually 5 or 10 years. The period for which the initial rate holds can be as long as 10 years or as short as one month.
Where the initial rate period is 3, 5, 7 or 10 years, the interest-only period is likely to be the same. Where the initial rate period is a month, 6 months or a year, the interest-only period will probably be longer. These are the cases where deception is most likely to arise.
4: 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.
There is no magic connected to amortizing an interest-only loan. A borrower who takes an interest-only option but decides to make the fully amortizing payment instead will amortize in exactly the same way as the borrower who takes the same mortgage without the option
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