How Does an Interest Only Loan Work?
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Terms
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When you contact a lender or mortgage broker for a loan, one of your options is an interest-only mortgage loan. Interest-only loans allow you to make monthly payments for a fixed term, such as 5 to 10 years, and the entire payment goes to interest. Your principal balance is never reduced during this time and your payment is not changed. Let's assume you have a 30-year mortgage and a five-year interest-only clause with a mortgage loan balance of $250,000. With a fixed interest rate of 6 percent, your monthly payment will be $1,250 for the entire five-year interest only term. If the loan was fully amortized, your total payment would be $1,498.88 and the portion going to principal would be $248.88.
Adjustment
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After the five-year interest-only period ends, the loan will now fully amortize for the remaining 25-year period. The payments will increase because a portion of your payment will now go to principal and interest instead of just interest. The new payment of $1,610.75 will be higher than $1,498.88 because the loan is being paid off and fully amortized for 25 years instead of the original 30 years. When you have an interest-only loan, you are not building any equity in your home because the principal balance is not decreasing. You build equity only to the extent that the value of your home appreciates over time.
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Options
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Normally, interest-only loans come with adjustable rates. If your adjustable rate loan adjusts after three years and you have a 30-year mortgage with a five-year interest-only clause, your rate could change and go up or down depending on the market rates at the three-year mark. Should the rate increase, your payment will increase and vice versa. When your interest-only term ends, you have the option of refinancing with the same lender or a different lender. During the interest-only period, you have the option of paying your full amortized payment, which helps to lower your principal balance, build equity and gives you a lower monthly payment when the interest-only period ends. People who are financially astute will pay the interest -nly payment and take the portion designated for principal and invest it elsewhere. You can invest the principal portion in an instrument that pays more than the 6 percent rate of the mortgage, which enables you to get a higher return. The amount can also be used to pay off high-interest credit card debt.
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