Interest only mortgages are just one of a handful of options for people looking for financing to buy a new home. Sometimes this mortgage option is used by investors who need to maximize cash flow while at other times it's utilized by individual home buyers to help them qualify for a larger amount than they would otherwise. The very nature of the interest only mortgage makes it a risky venture, but for those with the financial resources to cover the risks, it can be somewhat beneficial.
Interest Only Mortgage Defined
An interest only mortgage is one in which the borrower pays only the interest due for a set period of time. In most cases this period of time, also known as the I-O term, is either five or 10 years. But lenders have the freedom of making that number anything they wish, so it could be as low as three years. During the I-O term the monthly mortgage payment is calculated by simply taking the loan amount, multiplying by the interest rate, and dividing by 12.
For example, a $100,000 loan at 5% would mean annual interest payments of $5000. Divide that by 12 and you get a monthly mortgage payment of $416.66 plus taxes and insurance. With the interest only mortgage the principle is not reduced at all during the I-O term. It's also important to remember that interest only mortgages are considered to be a higher risk to the lending institution, which results in higher interest rates.
Once the I-O term has ended the borrower then begins to make principal payments in addition to interest, taxes, and insurance. Using the same $100,000 loan at 5%, the average homeowner could anticipate an increase of approximately $200 per month. Obviously, if property taxes increase during the I-O term, that additional amount will also be added to the new mortgage payment.
Fixed-Rate Interest Only Mortgages
The most common types of interest only mortgages are fixed-rate products. In other words, after the I-O term has ended, the principal on the loan will be amortized over the remaining number of years and interest charged at a fixed rate. That fixed rate will not change for the remainder of the loan period. Sometimes that interest rate is agreed upon when the loan is originally offered, and that's what is charged for the life of the loan, while at other times it is re-calculated once, based on the standard rate at the time the I-O term ends.
Among the two primary types of interest only mortgages, the fixed rate product is considered to be the safest for both parties. From the home owner's perspective, he can keep an eye on interest rates during the I-O term and know pretty much what he's going to pay once principal payments kick in. If he believes he can't afford it when the time comes, he'll have the remainder of the I-O term to either make adjustments in his finances or refinance altogether.
Adjustable-Rate Interest Only Mortgages
The second type of interest only mortgage is an adjustable-rate product, considered to be of the highest risk. What makes this type of mortgage so risky lies in the fact that adjustable rate give neither the homeowner nor the bank an adequate basis for future forecasting. Rates could go up or down, the financial circumstances of the borrower could change, and real estate values could remain flat or drop altogether. Because of the inherently higher risk, interest rates tend to be higher.
With these types of mortgage loans, everything remains the same during the initial 5 to 10 year I-O term. The home owner's payments go only toward interest with no reduction in principle. Once the I-O term has ended the principal is then amortized over the remaining years of the loan and interest charged at an adjustable rate as agreed to at the time of origination. There is however, one catch to this type of loan.
As a means of self-protection it’s pretty standard for banks and lending institutions to make the interest rate paid during the I-O term a fixed rate. This guarantees them some measure of stability in case the homeowner runs into financial problems at the end of the I-O term. There are some exceptions to this, but it's pretty standard practice.
Balloon Interest Only Mortgage
The balloon interest only mortgage is by far the least utilized in the industry. It allows the borrower to pay only the interest for a period of time ranging between three and 10 years, just as with the other two kinds. It is at the end of the I-O term where things get interesting. With this type of mortgage the borrower is required to make a balloon payment at the end of the term which is, in effect, the entire principle of the loan.
The balloon interest-only mortgage is used almost exclusively by investors who use the first few years to generate as much income from a property as possible. They tend to have access to more cash, or other financial means, so that at the time the balloon payment is due they can cover it easily. In fact, this type of mortgage is perfectly suited to the investor who has the right resources.
On the other hand, it could be the worst possible option for the everyday, run-of-the-mill homeowner. Balloon payments seem too far off in the distance to worry about when the loan is first originated. Yet the closer the home owner gets to that balloon payment, the more the pressure builds. If he does not have the financial means to make the payment he could lose the home. This is not a mortgage intended for the average home buyer.
At one time banks used to make provision for something called "negative amortization". With negative amortization a homeowner would be in a position where his monthly payments are less than the interest due at that time. Without building up equity during the I-O term this house begins to lose value because he owes more than the house is worth. By and large the practices that led to negative amortization were discontinued in 2008. With today's interest-only mortgages the original principal on the loan will never increase.