Interest Only Mortgage
THE INTEREST ONLY MORTGAGE (IO) requires the borrower to pay back only the interest portion of the loan on their home. This usually only lasts for a specific period, anywhere from 5-10 years. If the borrower strictly follows the interest only re-payment schedule, the principal or initial loan amount will remain the same at the end of the specified period. The IO (interest only) loan will not reduce the initial or principal amount on the loan. Take a look at the example.
Interest only Formula Explained
On a loan amount of $250,000 at 6% interest rate you would first: Take the balance and multiply it by the interest rate ( in decimals ) : 250,000 X .06= $15,000 Then divide by 12 ( months) $15,000 / 12 = $1250 So your interest only mortgage payment would be: $1,250 per month.Interest Only Loans Compared to a Fixed Rate Mortgage
On a traditional FRM ( fixed rate mortgage ), your monthly payment would be $1498 as opposed to the $1250 in our example above. Of course the major difference in the two loans is in the FRM you will have gained some equity in your home while in the interest only program you still owe the entire $ 250,000, even after dishing out $75,000 after five years living in the house! Remember, the 'Interest only' plan DOES NOT reduce the principal amount of the loan. All of payment goes toward the interest portion of the loan. After 5 years on a traditional FRM you would owe $232,664 as opposed to the IO where you would still owe $250,000.Interest Only Loans - Very Risky!
Interest only loans should be approched with caution - they can and do work for savvy homeowners when they've done their homework and can assume the risk involved. The major risk with this type of loan is you may end up owing more for your house at the end of the IO term than you originally paid! Since all the payments went to cover the "interest only" portion, the original loan amount stays the same. Now, if you want to remain in the house you'll have to refinace at the end of the term, typically 1-5 years after the original mortgage began. Hopefully, interest rates went down and you can get a lower monthly mortgage bill. However, interest rates can very easily creep up and cause a painful jump in your housing bill. Just a .25 %increase( 1 quarter of a percentage point) in interest rate from 6.00% to 6.25% increases the monthly cost from $1,498 to $1,539…Ouch! To sum it up: You've lived in a house for 5 years, don't have a dime of equity, and if interest rates go up you may not be able to afford to live in the house because the payment will no doubt go up also.For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
Interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences.
Interest-only mortgages can be a smart choice loan for those that have a valid reason to secure a lower initial required payment. Still, if you're considering this type of loan you must be ready to deal with the consequences.
Here are some reasons borrowers choose interest only loans (IO)
Pay Principal When Convenient: - If your income varies from month to month, the interest-only loan allows you to pay the smallest amount (the IO portion) when funds are tight. You can always pay more toward the principal when cash flow is better.
If you have the discipline to pay more than the minimum, you'll gain the benefit of reducing the principal amount of your loan.
You Can Buy "MORE" House - the interest only option allows first time buyers to start off with a more expensive home right off the bat. Buying a better house as income rises is expensive - moving fees, financing fees, time and effort to move…etc.
The interest-only loan makes it possible to skip to the second home NOW.
The risk involved here is the potential that your income won't rise which would enable you to make the extra payments to actually lower your principal. Ask yourself if that is something you'll be comfortable with.
Invest or Pay Down Your Mortgage? - If you have excess cash as a result of a lower monthly mortgage payment, you may benefit by investing that cash flow and hopefully at a higher rate of return than the mortgage interest rate you're paying.
If your interest only loan is at 6% and you're confident that investing in a diversified stock portfolio would generate 9.5% then this would be a valid rationale for choosing an interest only mortgage plan.
Again, you need to ask yourself if this is a good choice for YOU. Are you going to systematically invest the extra money or spend it? Financial discipline is the key here!
Also, are you ready to assume the risk that your invest speculations may not materialize? Using interest only loans as wealth building tools is very risky although not impossible…just understand the risks.
The Quick Flip - Many use the interest only loan in markets where home values are rising and are presumed to continue rising. If your homes value has increased within one or two years and you financed using an IO, large capital gains can be made if the home sold shortly after purchasing it.
The strategy used by many is to buy the most expensive home they can qualify for on an IO mortgage, and then only pay the minimum IO payment. In strong appreciation markets a 10%- 20% increase in a homes value can lead to large capital gains when sold.
Obviously the risk here is many don't understand the housing market well enough and get into trouble when their home doesn't sell as planned. Once your IO loan term is over (usually 1 year) you may be forced to refinance at a higher rate. If the value of the house goes up, qualifying for the new loan becomes an issue and foreclosure is a real possibility.