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Interest Only Loan

An Interest-Only Mortgage is:

An interest only mortgage is a scheduled monthly mortgage payment that consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers can pay more than interest if they want to. If the borrower pays interest-only every month during the interest-only period, the payment will not include any repayment of principal. If interest only is paid the loan balance will remain unchanged. For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. If borrowers have the same mortgage of 6.25% but without an interest only option, they would pay $615.72 per month. This is the "fully amortized payment" that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is "principal", which would be applied to the balance.

When are Interest Only Mortgages good for borrowers?

Pay principal when convenient: Borrowers with fluctuating incomes may value the flexibility the interest only mortgage gives them. When their incomes are tight, they can make the interest only payment, and when their incomes are better they can make a payment to principal.

Buy More House: This option allows buyers to take on a larger mortgage with a lower payment then without an interest only option.

Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth. However, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to work, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.

Capital Gain: An interest-only option is the instrument of choice in a quick turnover situation if you are trying to maximize the amount of house you can buy, and are limited by your income. The interest only option lowers the required initial payment, which allows you to qualify for a larger loan amount. The more expensive the house they can buy, the larger the expected capital gain.

Principal Reduction: On most interest only loans, whether fixed or adjustable rate, the monthly mortgage payment will decline in the month following a principal payment. This is the only type of mortgage that has this feature.

Hazards to be concerned with

The major hazard is being deceived into accepting an interest-only mortgage that does not meet any of the suitability tests described above. 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 interest only option will have a larger balance. Typically Lenders charge a higher rate for an identical loan with an interest-only option.

It is not true that 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.

Interest only 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.

On an interest only ARM, the quoted interest rate is fixed for the interest only period. 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.

It is less costly to amortize an interest only loan. 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. How Much More