Interest Only Mortgages (Fixed & ARMS)

The Interest Only Mortgage is exactly as the name implies. The loan payment is calculated by applying the rate to the outstanding principal balance. These loans are typically set up as ARMs, however, you can also get a 30-Year fixed rate mortgage with the first 10 years consisting of Interest Only payments.

These loans can be based on many different indexes, however, the most conservative are based on the Treasury Index or the LIBOR Index. Interest Only Mortgage payments have a payment minimum. If a borrower chooses to pay the minimum, then they will never reduce there principal amount owed.

The only way to lower the principal amount owed is to pre-pay an additional amount with every payment and have the additional payment credited towards principal reduction. Also remember that most Interest Only Mortgages have a maximum period for the interest only period.

This period can be as short as 60-months but usually never longer than 120-months. After this ‘interest only’ period the loan is amortized for the balance of the mortgage. This balance is calculated as the time difference between the interest only period and 30 years. So in a loan with 120 months (10-Years) of interest only payments, there would be 20 years of amortized payments after the interest only period.

Who should apply for this type of loan? The Interest Only Mortgage is great for loans with high balances on homes that are in markets with rapid appreciation. The payment savings can be substantial.

Consider this scenario, on a $250,000 loan balance with a standard 30-year fixed rate mortgage at 6%, the principal and interest payment would be $1,492 per month. On a 3/1 Interest Only ARM with a 4.75% rate the interest payment would be $990 per month. That is a savings of approximately $500 per month. On Jumbo Mortgages the savings are even more pronounced.

Final Note:   Remember these important tips when obtaining an Interest Only Loan;

 There is no principal reduction, so make sure that you are located in a market with appreciating values and that you know how your mortgage financing fits into your overall investment plans and goals. Interest Only Mortgages are best for loans with high balances and on homes that are located in markets with rapidly appreciating home values.

Watch out for pre-payment penalties. These loans are considered an ARM instrument and many ARMs have hidden prepayment penalties. Interest Only Mortgages come in 1-month, 6-month, 1-year, 3-year, 5-year and 7-year, 10-year ARM style loan programs and some lenders carry a 30 year fixed with the first 10 years as interest only as well.

One final comment… Interest Only loans are considered to be ‘exotic’ mortgages.  They should only be used with the advice of a financial planner or CPA’s advice.  Not seeking council before pursuing this type of loan is just like going to Vegas and rolling the dice!