Interest Only Mortgage And How They Work

interest-only mortgage

Consumers looking to finance a home will be pleased to learn that interest rates are now at historic lows. In today’s low-rate market, you may be considering mortgage options in a new light, such as having a mortgage that allows you to pay the least amount of interest. While an interest-only mortgage may appear to be the best option, there’s more to this loan than you might think.

A brief history of interest-only mortgage

Customers could borrow on an interest-only basis without showing lenders how the debt would be repaid before the 2008 financial crisis, and interest-only lending soared ahead of the crisis. Following the credit crisis, it became clear that hundreds of thousands of interest-only borrowers would face difficulties repaying their mortgages in the future.

As a result, borrowing on an interest-only basis has become very difficult. Not all lenders offer interest-only loans, and those that do will have strict requirements in places, such as a substantial deposit and a pre-approved repayment vehicle to pay off the capital at the end of the term.

The only exception is buy-to-let real estate. Many landlords solely pay the interest on their mortgages, which lenders commonly accept.

In any case, if you can’t return the loan at the end of the term, you’ll have to get a new mortgage or sell the house to pay off the debt.

Interest-Only Mortgage

An interest-only mortgage is one in which the mortgagor (borrower) is only obligated to pay interest on the loan for a set length of time. The principal is returned in a lump sum at a predetermined date or in installments.

Interest-only mortgages come in a variety of forms. Interest-only payments can be paid for a certain amount of time, as an option, or for the entire term of the loan.  

How Do Interest-Only Mortgages Work?

An interest-only mortgage is simple during the first 5 or 10 years of the loan: the borrower pays only the interest payable on the loan.

Things get more expensive after the interest-only period ends. Because you’re paying both interest and principal over a shorter period in year six, the principal begins to amortize, and your entire monthly payment on the loan grows significantly.

Adjustable-Rate Interest-Only Mortgage Loan 

The majority of interest-only loans are made up of adjustable-rate mortgages (ARMs). Interest-only loans are typically arranged as a 3/1, 5/1, 7/1, or 10/1, with the top number (3, 5, 7, 10) indicating the number of years you’ll be paying interest only.

The bottom number (the “1”) represents the number of times the mortgage rate is modified each year. This means that the interest rate on your loan changes once a year (and only once a year) based on current rates.

Don’t be alarmed by the concept of an ARM. Rate limitations are standard on all ARMs, which means your interest rate will never surpass a specific percentage. This prevents your interest rate from skyrocketing. Also, you can’t calculate your mortgage over time because rate changes are unpredictable. However, you may take out an adjustable-rate mortgage with the assurance that you won’t be screwed afterward because you’ll know the rate cap.

Fixed-Rate Interest-Only Mortgage Loans

Interest-only mortgages with a fixed rate are less prevalent. You might pay interest only for the first 10 years of a 30-year fixed-rate interest-only loan, then interest plus principal for the final 20 years. If you didn’t contribute anything to the principal during the first ten years, your monthly payment would skyrocket in year 11. Not only because you’d start repaying principal but also because you’d be repaying principal over 20 years rather than 30. 

Since you aren’t paying down principal during the interest-only term, your new interest payment is based on the whole loan amount when the rate resets. A $100,000 loan at 3.5 percent interest would cost $291.67 per month for the first 10 years, then $579.96 per month for the next 20 (almost double).

The $100,000 loan would cost $174,190.80 over 30 years, based on ($291.67 x 120 payments) + ($579.96 x 240 payments). Your total cost over 30 years would be $161,656.09 if you took out a 30-year fixed-rate loan at the same 3.5 percent interest rate (as described above).

That’s an extra $12,534.71 in interest on the interest-only loan, which is why you don’t want to keep an interest-only loan for its whole period. If you take the mortgage interest tax deduction, however, your real interest expense will be lower.

Conclusion

To get the most out of an interest-only loan, you’d have to sell the house or refinance to a conventional loan before the interest-only period ends and the payment increases to a higher rate.

It’s crucial to remember that because an interest-only mortgage has an interest-only payment period doesn’t mean borrowers can’t pay more than the interest if they want to. Many people appreciate the ability to pay more than the minimum payment to reduce debt and develop equity.

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