Interest Only Loans

Highlights

  • An Interest Only mortgage starts with low payments.
  • However, your payments will increase due to the payment structure and interest rate change.
  • Make sure that you can handle the changes and consider other less risky alternatives.
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Interest Only Mortgage Loan - Changes Ahead

An interest only mortgage loan has an easy beginning, but be prepared for changes. Your interest payment period will expire and your loan will come with a variable interest rate.

Buying your dream house takes planning. Save money for your down payment and budget correctly to make sure that you can afford your monthly payments. Before shopping for a home, figure out what you can afford. It is tempting to buy a bigger piece of property, but make sure that you can really afford it. What happens if your income drops, or you have emergency expenses, or the cost of living increases?

An interest only mortgage helps keep the monthly mortgage payment down to an affordable monthly payment. However, make sure that you are able to manage the risks and:

  1. You have the ability to make monthly payments even when the monthly payment increases
  2. You can handle a deficiency balance if you have to sell your house and the sell price does not cover your loan.

In order to help you determine if an interest only mortgage is right for you learn about: 

  • Using an Interest Only loan to Buy more House
  • Interest Only Loans: The payment schedule ( A 30 year FRM - Payment comparison)
  • When to consider an Interest Only loan

Housing and Mortgage Affordability

The main reasons borrowers consider taking an Interest Only mortgage loan is to make their payments low and/or buy a larger place. This can be appropriate for people who have uneven cash flows, for example:

  1. Self-employed with seasonal income
  2. Employees who receive large annual bonuses.
  3. Young people who are starting a career, with a strong outlook for steady increased income.
  4. Anyone who can afford to carry the risk of a higher monthly payment, but wants to use the extra funds for investment purposes or college education.

Before you start to look for a special type of loan, like an Interest Only mortgage loan, prepare yourself by evaluating how much home you can afford using the most common long-term mortgage product, a 30-year FRM.

Lenders will evaluate you based on your credit score and your DTI (debt-to-income) ratio. A common rule of thumb is that your monthly mortgage and property related expenses should not be more than 25% of your monthly gross income. In addition, your overall monthly debt payments (including credit card, installment debt and property related expenses) should not be greater than 36% of your monthly gross income.

In order to see how much you can afford, use Bills.com mortgage affordability calculator. Based on your income, amount of down payment, monthly debt payments and property related expenses, the calculator will provide you with a minimum and maximum price housing price. The prices are based on a 28% or 36% DTI ratio.

Quick tip
Look at Bills.com mortgage rate table to learn about today’s interest rates.

Interest Only Mortgage - The Payment Schedule

Although an interest only mortgage can be offered as a fixed rate mortgage, it generally is an ARM (Adjustable Rate Mortgage). The beginning part of the loan has a fixed interest rate and interest only payments. Then, as the interest rate is adjusted, you begin to make principal and interest payments.

That means you are carrying the sure risk that your payments will increase (due to the new payment structure that includes principal and interest) and the added risk of an increase in the interest rate. ARMs come with caps and ceilings and make sure your lender explains exactly what they are.

I/O Mortgage Loans: Slippery Road Ahead Here are some typical Interest Only (I/O) mortgage loans:

  • 5/1 I/O ARM: The interest rate is fixed for the 5 year, during which you pay only interest. After that initial period you interest rate changes every year, as do your monthly payments, including principal and interest, which are amortized over the remaining period. In general, these are 30-year loans.
  • 10/1 I/O: The only difference is that the interest rate and interest only payments are set for the first 10 years of the loan. In order to help you compare loan options here is a chart that compares a 30 year FRM to a 5/1 I/O mortgage.

In order to simplify the comparison let’s assume that the annual caps are 2% and the ceiling is 10%.

  30-Year FRM 5/1 Interest Only
Loan Amount $300,000 $300,000
Initial Interest Rate 3.5% 3.9%
Initial Payment $1,347 $975
Year 6 Payment no change $1,569 (no interest rate change)
$1,914 (interest rate changes 2%)
Maximum Payment no change $2,691 (at 10% ceiling)

The interest rates used are for illustrative purposes only.

Since an ARM loan has a built in interest rate risk, and an Interest Only loan has a payment structure risk, be prepared for the changes in your payment schedule. It doesn’t mean that the payments will be the maximum, but it does mean that you need to be able to deal with the fluctuations. If you can’t afford it, then don’t take it.

When to Consider an Interest Only Mortgage Loan

Now that you understand that an interest only loan has built in risks and changes ahead, you can better evaluate your choices. If you are like most people who are purchasing or refinancing their home who have a steady and stable income, looking to build equity in their home and be mortgage free, then stick with a 30 year FRM, or if you can afford larger payments, then a 15 or 20 year FRM.

However, consider taking an Interest Only mortgage loan if you fit into one of these categories:

  1. You can stick to your budget, and apply extra funds to pay down your mortgage loan.
  2. You have large asset reserves and do not need to build your equity through your mortgage payments. This is especially true if you are purchasing or refinancing an investment property. Your initial low payments will let you build up reserves, and you can then hope to pay off the loan when the property increases in value.
  3. Your income is variable or seasonal and you want to keep your payments down to the minimum.

Remember that risks do exist, and don’t count on the best-case scenario. Compare different loan options. Your interest only mortgage loan will come at a premium, so compare it to a 30-year FRM or ARM.

quick tip: in order to get the best mortgage loan available for your circumstances, get a mortgage quote from one of bills.com mortgage providers.
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