What Is An Interest Only Mortgage?
Interest Only Mortgages
An interest-only mortgage does not decrease the principal loan amount but rather the installments only cover the interest charged on the loan amount every month. This means that you will always owe the same amount to your loan provider as you are just paying the interest. While there is a small niche market for these type of loans, they are not for everyone.
These type of loans are secured by the property that has been purchased. Although there is an option to pay more than the interest, this option is rarely taken. An interest-only mortgage is popular because it greatly reduces the monthly installment on the mortgage. However, these types of loans do have a bad reputation and are often made out to be high risk. Just like most types of mortgages, this type of property financing option does have both advantages and disadvantages and when used correctly under the right circumstances, can be highly rewarding.
How Does An Interest-Only Mortgage Work?
The principal loan amount is not taken into account when calculating monthly installments. Only the interest charged on the loan will need to be repaid on a monthly basis. For example:
A principal loan of $100,000 bearing 6.5% interest amortized over 30 years would result in a monthly repayment of $627 including both the principal and the interest (P&I). The interest portion of this amount would be $541.50. This would result in a monthly saving of $85 when taking an interest-only loan.
Different Types Of Interest Only Mortgages
Most types of mortgages that provide an interest-only option do not have an unlimited term. In other words, you cannot continue only to pay the interest forever, and after a specified period, the principal loan amount becomes fully amortized over the remaining term of the loan. For example, a 5/25 mortgage would allow for interest-only payments for the first five years of the 30-year term, and after that, the principal loan amount will be amortized over the remaining 25 years of the original term when both interest and principal amount will form part of the monthly repayment.
To give you a better idea of how this works, look at these to popular options:
- A 30-year mortgage – The option to pay only the 6.5% interest for the first 5 years on a principal loan amount of $200,000 will result in repayments of $1,083 per month for the first 5 years and $1,264 for the remaining 25 years of the term.
- A 40 year mortgage – The option to pay only the 6.5% interest for the first 10 years on a principal loan amount of $200,000 allows for an interest-only payment in any chosen month within the initial 10 year period and thereafter, installments will be in the amount of $1,264 for the remaining 30 years of the term.
How To Calculate An Interest Only Payment
It is easy to calculate interest on a mortgage:
- Multiply the principal loan amount by the interest rate. In the above example, this would be $200,000 multiplied by 6.5 which is $13,000 in interest annually.
- Divide the annual interest by 12 months and you arrive at your monthly interest payment on your mortgage. $13,000 divided by 12 equals $1083 which is what you will pay in interest on a monthly basis.
How Can You Benefit?
An interest-only loan is ideal for a first-time home buyer. Most new home buyers do not have the available income to afford to repay a conventional mortgage and therefore opt to rent rather than purchase.
The option to pay the interest-only in any given month provides the homeowner with some financial flexibility when it comes to unforeseen circumstances. In other words, the homeowner does not pay only the interest every month but can choose to do so when they need to during a month of financial difficulty or where an emergency has arisen that prevents them from making a full repayment.
Self-employed individuals or commission earners who do not earn a stable monthly income can also benefit from these type of loans. In high earning months, they can pay more towards the principal amount and in low-income months, opt to pay only the interest on the mortgage.
What Does It Cost?
Due to the slightly higher risk that a loan provider may run in offering an interest-only mortgage, these type of financing options are often a little more expensive than traditional mortgage options. Most often, the difference is as low as 0.5% in the interest charged on the principal amount.
Additional fees may also apply as may a percentage of a point on the principal amount in order to grant the loan.
Misconceptions And Real Risks
The balance owed on the mortgage will never increase as it does with ARM loans. Increasing the balance is referred to as negative amortization and does not apply to interest-only mortgages.
The most significant risk is when it comes to selling a property which has not appreciated in value. If the principal amount has not been reduced due to paying interest-only, the loan amount will not have changed, and therefore the full amount will become due. This will mean that the homeowner will run at a loss.
On the other hand, it is important to note that this is a risk that is run when taking out a conventional mortgage. It is rare that a loan will cover the costs of a selling a property that has not appreciated in value. A significant down-payment will reduce the risk factor on an interest-only mortgage.
A drop in the property market can result in the loss of equity on the property. Once again, the risks associated with a decline in the property market is run by all homeowners whether they opt for an interest-only mortgage or a home loan that is fully amortized.