What is an interest only mortgage?

With the traditional mortgage loan, you pay back the loan balance each month with interest. For example, here's how the monthly loan payment looks for $100,000 at 5% for a 30 year term.

You'll notice that the interest is paid first and the principal balance part of the loan payment is considerably less. As the months pass, the interest part of the monthly payment decreases and the payment is mostly principal.

Unlike the traditional "fully amortization" mortgage, the interest only mortgage is just that, your monthly loan payment is the interest "only" part of the monthly loan payment. Most interest only loans have a fixed term of between 5 to 10 years. After the initial interest only term, the loan converts to the traditional fully amortization payment arrangement. Since there is no principal reduction during the interest only period, the loan balance remains the same. If you borrowed $100,000 and the interest only period was for 10 years, after ten years, the principal balance would still be $100,000!

The interest only mortgages (depending on the lender) allow the borrower to make an additional payment each month. The additional payment is applied to the principal balance.

Interest only fixed rate or adjustable interest rate

The interest only mortgages are offered with a fixed interest rate or an adjustable interest rate during the interest only period. With the fixed interest rate, the interest only payment will remain the same each month (assuming no additional principal payments).

But the borrower could choose an adjustable interest rate. As the name implies, the interest rate can adjust up, down or remain the same. The interest rate is subject to an interest rate change every 12 months. The benefit of an adjustable rate interest only mortgage is that the initial interest rate is lower with the adjustable rate option than the fixed interest rate.

5/1 Adjustable Rate Mortgages (ARM's)

Many lenders offer a mortgage that is interest only for the first 5 years and then converts to an adjustable rate mortgage after 5 years. The interest rate is subject to change each 12 months after the first 5 years (60 payments).

How much can I borrow?

The interest only loans usually meet the "conventional" lending guidelines and maximum loan amounts, however, some lenders will exceed the customarily lending limits of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Company (Freddie Mac). Interest only loans that exceed the annual loan limit are called jumbo interest only loans.

Advantages of Interest Only Loans

The obvious advantage of an interest only home loan are the lower loan payments each month during the interest only period, especially if the adjustable rate option is chosen.

Since the monthly loan payment is less than the fully amortizing loan, the borrower is able to borrow more money which in turn means the borrower is able to purchase a more expensive home.

In a rising real estate market, the home builds equity and the loan balance relative to the market value is less significant.

Disadvantages of Interest Only Loans

At some point, the interest only mortgage will convert to either a fixed or adjustable rate mortgage. If no additional principal payments were made during the interest only period, the borrower could face a payment shock if the new interest rate is significantly higher than the initial interest rate.

Lenders who offer interest only mortgages require a higher credit score and a larger down payment, as much as 20%.

Should you take out an interest only mortgage?

If you're buying a home in a tight real estate market, an interest only mortgage may give you some extra buying power to purchase a home.

If you believe your income will increase, and you will be able to make additional monthly payment on the mortgage each month, an interest only mortgage might be a good mortgage choice.

If you're a corporate gypsy and know that you are going to be transferred, an interest only mortgage could be a good choice in a rising real estate market.