Removing the Mystery from ... Interest-only Mortgages

With the level of foreclosures making headlines in our state, this is a good time to discuss the very popular but much maligned interest-only loan products. There are pros and cons to these types of loans but, if understood, you can make an informed decision on whether one is right for you.

What is an interest-only loan?

An interest-only (IO) loan requires that only interest be paid for a set period of time – usually anywhere from 3 to 10 or 15 years. During this period, the loan does not have to be “amortized”, meaning that principal payments are not required – though you can generally make extra payments toward principal if you so choose. The advantage is that the monthly payment is smaller at first, but all IOs will eventually require that you pay principal to begin amortizing or “killing off” the loan.

As an example, a fully amortizing 30 year $200,000 note at 6% carries a payment of approximately $1200/mo. But in the early stages of the loan, about $200 of this is principal. So the interest-only payment is reduced to about $1000/mo. This payment remains the same until the “recast” period when you must begin to fully amortize the loan over the remaining term. If your IO is an adjustable rate mortgage (ARM), you may receive a double whammy as your rate adjusts as well.

What types of products are offered?

Many IO’s come in the form of a hybrid ARM, i.e. a 3/1 to 10/1 where the rate is fixed for 3 to 10 years and then adjusts annually. But there are 30 year and longer fixed rate varieties that are interest only for usually 10 or 15 years. Your payment may adjust if you keep the loan for more than 10 years, but your rate will not. Then there is the so-called “payment option ARM” - each lender has a different name for it but most of them share the same basic concept whereby you have several different payment choices, one of which is an interest-only option with the rate adjusting monthly. This type of loan is not my personal favorite, but it has its place for the right borrower. If you don’t fully understand the product, you might wish to avoid it.

Does an IO cost more?

Generally yes but not always. Some IOs carry a similar or even better rate than their fully amortizing counterparts but others may be slightly higher because the lender is taking on greater risk. The underwriting requirements can sometimes be more stringent as well.

Should I consider getting an IO loan?

If cash-flow is an issue or you would prefer to use your cash elsewhere, than yes, an IO may be ideal for you, particularly when borrowing rates are low. An IO is especially useful if you earmark your cash savings for the build up of a separate investment account – keeping your cash liquid as opposed to locking it up in home equity. The key here is “conservation”, not “consumption”. And if your property appreciates, you will build equity through that channel. In addition, you may be able to prepay principal at any time if you like, thereby gaining some equity and reducing all subsequent IO payments. Reducing your next monthly payment is something you generally cannot do with a fully amortizing loan.

But an IO can be hazardous if you’re not disciplined. The primary risk factors are that you are not required to pay equity-building principal – a kind of forced savings - and your payment could jump substantially at the recast period when you are required to pay principal to amortize the loan and quite possibly take on a higher interest rate if you have an ARM.

The real danger lies in taking out an IO loan with a minimal or no downpayment and sparse assets to bail yourself out should you need to sell. Remember, selling your home can incur substantial costs and if your home hasn’t had time to appreciate in value and you have no equity, you may have to bring a large sum of cash just to sell your house – a foreclosure in waiting.

Finding the right mortgage is a huge decision that can affect your finances for many years to come. Take the time to understand your options and the ramifications of each. Just because your lender says “yes” to your application doesn’t mean that it is the right loan for you.

If you would like to explore this option further, I’m always happy to answer questions about all loan options.  As always, my goal is to help you make an informed decision on your new purchase or refinance.