Explain Interest Only Mortgage Loans
Interest only mortgages are a mortgage option to allow the homeowner to have a lower payment than with a standard mortgage. An interest only mortgage may work for certain homeowners but could cause some serious financial problems in the future for others. If an interest only option is available for a new or refinancing homeowner she should look closely at the consequences before picking the interest only mortgage for the lower payment.
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Features
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With an interest only mortgage, the homeowner makes payments that amount to only the interest due on the mortgage principal. This is in contrast to a standard, amortizing mortgage in which each payment is part principal and part interest. The interest only option results in a lower payment. Interest only mortgages are in the interest only mode for a limited period of time, typically for three, five or 10 years. Then the mortgage amortizes and the principal is repaid over the balance of the 30-year mortgage term.
Effects
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The best way to see the effects of a principal only mortgage payment is to compare it with an amortizing mortgage. Compare a $200,000 mortgage with a 6.5 percent interest rate and an interest only period of five years. The initial interest only payment is $1,083.33. A regular, amortizing mortgage would have a principal and interest payment of $1,264.14. The interest only payment is $180.81 lower every month. At the end of the five-year interest only period, the amortizing mortgage has a principal balance of $187,222 and the interest only mortgage is still at $200,000. In the sixth year the payment on the formerly interest only mortgage will be $1,350.41, an increase of $267.08.
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Significance
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The homeowner with an interest only mortgage will not pay down any of the principal balance during the interest only period. After the interest only period, the payment can increase significantly. If the home has not appreciated significantly in value, the homeowner has made payments for several years without gaining any equity. The attractive lower payment of the interest only option can be a trap when the interest only period runs out.
Considerations
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Mortgage lenders consider interest only mortgages to be higher risk loans. Borrowers are not paying down any principal amount, leaving the balance due to the lender at the original amount. To compensate for the additional risk, most lenders will charge a higher rate for interest only loans. According to the Mortgage Professor website, interest only rates are 0.375 to 0.875 percent higher than conventional mortgage rates from the same lender.
Benefits
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Interest only loans are appropriate in a few circumstances. If the borrower has uneven income but receives large bonuses or other forms of income, the interest only option keeps the monthly payment low and the homeowner can make principal payments when they receive larger sums of money. In a time of rapidly rising home prices, interest only payments work if the homeowner can sell the home in a few years for a nice profit.
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References
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