What Does an Interest Only Loan Mean?
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. The monthly payment is $536.82.
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.
Frequently
Asked Questions About Interest Only Mortgages
Q. Are ARM loans interest only?
A. adjustable-rate mortgages can be amortizing or interest only
Q. Can I sell my house if I have an interest only mortgage?
A. Houses can be sold with an interest only mortgage, provided there
is sufficient equity to payoff the interest only loan. If the sales
price is less than the loan balance, the homeowner will need to bring
cash (check) to settlement.
Q. Can you pay off an interest only mortgage early?
A. Yes
Q. Can you refinance an interest only mortgage?
A. Yes
Q. What are the disadvantages of an interest only mortgage?
A. 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%.
Q. What are the advantages of an interest only mortgage?
A. 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.
Q. Why would you have an interest only mortgage?
A. 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 an 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.