What is an Interest-only Mortgage?
An interest-only mortgage is one alternative mortgage option a home buyer may consider instead of the standard 30-year fixed-rate mortgage. The interest-only option will result in a lower initial monthly mortgage payment and will make the home you want more affordable. Interest-only loans can have a fixed rate for the life of the mortgage or have the rate fixed for the interest-only period then convert to an adjustable rate mortgage, or ARM.
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Interest Only Compared
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The standard 30-year mortgage has an amortizing payment. This means each monthly payment includes interest on the loan and a principal amount to pay down the loan balance. After 30 years of the level payments, the loan is completely paid off. An interest-only mortgage has monthly payments consisting of just interest on the loan. No principal amounts are included in the payment and the loan balance does not decrease. The result is a lower payment. On a $250,000 loan at 6 percent, the payment on a standard mortgage would be $1,499 per month. An interest-only loan for the same amount and rate has a payment of $1,250.
Cost of Interest Only
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Interest-only mortgages are usually not available at the same rate as a standard amortizing mortgage. The Mortgage Professor website found an average rate premium of 0.375 percent for the interest-only option. On the example loan used here, the interest-only payment at 6.375 percent would be $1,328, reducing the savings for selecting interest-only to $122 per month. An interest-only loan that converts to an ARM after the interest-only period may have a lower rate and higher payment savings than the fixed-rate, standard mortgage.
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Long-Term Costs
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Interest-only loans have the interest-only payment amount for the first five to 10 years of the mortgage. After the interest-only period, the payment is recalculated and the loan is paid off in the remaining term. The result is a sharp increase in the payment. For example, the $250,000 loan at 6.375 percent would have the payment go up to $1,728 after a seven-year interest-only period. This is a $400, or 30 percent, payment increase.
Considerations and Options
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An interest-only loan may make sense if the home buyer knows for sure she will sell the home before the interest-only period ends. The interest-only loan balance does not decrease, so any equity buildup will only come from an increase in the home value. The $250,000 standard mortgage will pay down by $26,000 in seven years. Home buyers looking for lower payment options may want to consider 5/1 or 7/1 hybrid ARM loans with amortizing payments. These mortgages have the interest rate fixed for the first 5 or 7 years and the rate and payment will be less than a 30-year, fixed-rate loan.
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