Interest Only Mortgage Loan - Home Loan - The Details and Principal Facts

The Interest Only Mortgage Loan - The History, Details and Principal Facts

For starters, the name can be very misleading. There is no such thing as an Interest-Only Mortgage Loan, because eventually you will have to pay the mortgage loan principal. What you are actually receiving is an Interest-Only Mortgage Loan payment method which can be combined with any type of traditional mortgage loan.

The other thing you need to keep in mind is that the benefits are way overblown. In the beginning years of a standard mortgage loan, the interest takes up about 95 cents of each dollar paid to the mortgage lender. The standard mortgage payment on a 6% loan, $100,000 loan is about $600 per month; of that, $500 is interest, saving you an approximate $100 per month. Moreover, not paying any principal now means that you'll pay more interest in the future.

Some History about Interest Only Mortgage Loans

Interest-Only Mortgage Loans are not brand new to the market. Instead, like many other innovative methods, they originally started out of the less rigid and more inventive jumbo mortgage loan markets. (Mortgages Loans for amounts larger than the Fannie Mae Loans and Freddie Mac Loans can purchase are called Jumbo Loans).

These Mortgage Loans were typically aimed at savvy investor type clients who preferred to utilize what would have been the principal portion of their mortgage payment for other, hopefully more productive investments.

Because they were mostly Jumbo Loans, obviously the difference in the monthly mortgage payment grows with the larger mortgage loan amount. The $100 per month difference in the above $100,000 example above grows to $1,000 per month on a $1,000,000 mortgage loan, which is a substantial amount of cash that could have been put to better use. For example, while real estate might produce a return of investment of the inflation rate plus a couple additional percentage points, putting that money to work in the stock market instead could offer much higher return. An investor might just be able to grow his investment very rewardingly in a short period therefore leveraging their incomes to build their asset strength.

This is a viable use of Interest-Only Mortgage Loan payments, but naturally there are other risks, especially in stocks. However, the type of investor-type people we are talking about here normally has assets sufficient to help offset the risks of not paying off their homes should they need to sell or refinance.

Most Interest-Only Mortgage Loan payment schedules are offered on Adjustable Rate Mortgages, but they are also found on fixed rate mortgages as well. They've also entered into the market mainstream, so that they're available to just about any and all borrowers. The mortgage loans you'll find will usually be sold to a secondary mortgage market dealer, so let's take a look at the Fannie Mae mortgage loan program.

Fannie Mae makes purchases from mortgage lenders an interesting version of a fixed rate mortgage loan featuring Interest-Only Mortgage Loan payments. Called Interest First, it features back-to-back 15 year term, with the first period comprised of Interest-Only payments and the second fully-amortizing. It is expected to pay a little extra for this loan product. The interest rate for the Interest First loan product is slightly higher then the interest rate for a similar, but fully-amortizing loan product.

Information on Interest Only Mortgage Loans can be found here.

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Interest-Only Mortgage Loans are not forever

Interest-Only Mortgage Loan payment periods almost never run for the entire term of the mortgage loan, even when a fixed rate mortgage is the underlying instrument. Even the Interest First loan product only allows for Interest-Only payments for one-half of the total loans term.

Interest-Only Mortgage Loan payments more typically end at the end of a set time period, making them a frequent companion to Hybrid Adjustable Rate Mortgage Loan. Once the Interest-Only period comes to an end, your monthly payment will increase to include both principal and interest.

Interest-Only Mortgage Loans - Then and Now

Where Interest-Only Mortgage Loan payment methods were formerly used for income leveraging purposes (using the same income to buy a home while accumulating other assets) today's mortgage loans aren't being pitched only to well-to-do, sophisticated investors. While cash-flow purposes are still common, another common audience with a different need has developed.

In the past several years, low mortgage loan interest rates, affordable housing initiatives, and creative financing options have served to drive millions of potential homebuyers into the real estate marketplace. That new demand has, surpassed the supply of desired homes, leading to what is termed a Seller's Market, in which lots of potential buyers compete for these desired homes. This demand, in turn, has allowed the home sellers to ask more for their homes. Buyers without substantial income or assets strength may have found themselves outbid. Affordability, helped by the falling mortgage interest rates, was now compromised by rising values and home prices.

Debt-Leveraging

Interest-Only Mortgage Loan payment options began to be offered to the millions, as a way to borrow more money while not increasing the monthly mortgage payment. In the example described herein, the monthly mortgage payment of $600; about $500 of that is interest only, and only about $100 goes toward repaying the principal loan amount. With an Interest-Only arrangement, all of the $600 pays the mortgage interest cost.

That extra $100 in monthly payment flexibility allows you to borrow an additional $20,000 or to help you buy a somewhat larger home. Borrowers employing this method aren't cash-flow or income-leveraging borrowers. What they are doing is buying more debt. Making them Debt-Leveragers.

Leveraging and Risk

Of course, the sophisticated investors completely understand that with an increased leverage comes an increased risk. In this case, the borrowers who utilize Debt Leveraging themselves into a more expensive home, with a larger mortgage payment, gamble not only that their income will increase in the years to come, but that the home will appreciate as well. Since the principal balance is not being reduced, they're not building any equity in the home. Instead, they are counting on the real estate market to do this for them. This isn’t so much of a gamble when home’s values are appreciating, but it could be big trouble in a downward real estate market.

At the same time, these borrowers are betting that when the higher monthly payments are due, they will have substantially increased their income enough to cover these increases.

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Term Compression and Payment Risk

Most of these examples so far have only dealt with Interest-Only Mortgage Loan payments overlaid on a fixed-rate mortgage loan. For ease of explanation, so will this example. However, we’re going to limit the Interest-Only payment period to 5 years, after which a fully amortized payment will be required.

In a fully amortized mortgage loan, the monthly payments are based on the full term, typically a 30 year term. The $600 example above is based on a full 30 year term, with the Debt Leveraging borrowers spending all of that $600 on interest costs alone ($120,000 loan amount). After 5 years, the Interest-Only period ends and the borrower still owes $120,000 at 6%. However, this borrower no longer has 30 years over which to repay the outstanding mortgage loan balance; he has only 25 years. And since the monthly mortgage payment is calculated on that shorter repayment term, the guaranteed result is a higher monthly mortgage payment: it jumps from $600 (Interest-Only) to $773 (fully amortized). That $173 represents a 29% increase in the monthly mortgage payment, so the borrowers are actually betting that their income will have increased by at least this much. (By comparison, a fully amortized $120,000 mortgage loan at 6% would have had a fixed monthly mortgage payment of $719).

In our example, over the first 5 years, the borrowers would have spent $34,833 in interest only. Over the remaining 25 years, total interest charges would be an additional $111,949 for a total of $146,782 in interest cost. If the borrowers had taken a fully amortized 30 year fixed rate mortgage loan with the same specifications, the total interest cost would have been $139,006. In short, that Interest-Only monthly payment scheme cost nearly an additional $8,000 over the full term of the loan.

Most borrowers do not usually remain in their mortgage loan for a full 30 years, so such an argument doesn't apply to all borrowers. However, a fully amortized mortgage loan as above, after 5 years, has an outstanding principal balance of $8,300 less than the Interest-Only one does.

Market Risk I

Not repaying any principal, and therefore not building any equity through debt retirement, means that an Interest-Only Mortgage Loan borrower is counting on real estate market appreciation (price inflation) to help own more of the home. Of course, this requires that values and prices increase while she holds the Interest Only mortgage. Now, those who follow the national real estate markets are quick to point out that there hasn't been a broad decline in home prices since the Great Depression. However, you don't own the national real estate market; you own a single house in a single neighborhood, in a single town, and those followers will also concede that values and prices can and do increase and decrease regularly on a localized basis.

So what does this mean to the Interest-Only Mortgage Loan borrower? It means, there is a danger in not reducing the principal mortgage balance. If the home prices should fail to increase during the Interest-Only period or the loan, and if the borrower should find a need to sell the home, they could potentially be on the hook for thousands of dollars in sales costs, which would need to be paid out of whatever equity they started out with.

Market Risk II

The more extreme side of Market Risk I, is that values and prices actually decline during the mortgage loan holding period. If a borrower finds themselves in this situation, coupled with a low down mortgage payment, they could easily find themselves underwater (a term that means they will sell the property for less than the remaining principal balance of the mortgage loan). In this unfortunate event, the borrower cannot sell the home, without somehow coming up with what could likely be several thousand dollars.

We noted before that monthly mortgage payments made in the early years of a fully amortized mortgage loan are largely comprised of interest portions. However, in the examples herein, we noted that a fully amortized mortgage loan is paid down by about $8,000 after 5 years. This is enough to cover the sales costs for a $130,000 home.

Interest Rate Risk

All the above examples, so far have been based on mortgage loans with a fixed interest rate. Unfortunately, most of the Interest-Only Mortgage Loans being made in today’s market, feature only a short fixed interest period, if any; some feature an adjustable rate which can change each and every month. As this is written, low mortgage interest rates, with some short term interest rates at or near historic lows.

Above, we discussed term compression and its effect on monthly mortgage payments, which causes them to increase above what they otherwise would be when the Interest-Only period term ends. Now, magnify that compressed repayment term with a jump in mortgage interest rates, and you've got a fiscal catastrophe.

Figure this: say the Interest-Only borrower has been happily making monthly mortgage payments at $600 for the first 5 years of a fixed rate mortgage loan. All the while, mortgage interest rates have been rising from their 40 year lows to what could be considered normal and the monthly payment increases over 40% to $848 per month. In a period of considerably higher mortgage interest rates when the fixed rate mortgage and Interest-Only period ends, the rate could jump to 9% or more (in which case the monthly mortgage payment could jump to $1,000 per month, or even more).

Also at the moment in the mortgage market, liberal and flexible mortgage underwriting guidelines are allowing borrowers to borrow more money with the same income, because qualifying ratios have been greatly increased. So, theoretically, a borrower's budget could already be stretched to the maximum limit (and that's before a bad rate and payment hike).

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The Good News

Interest-Only Mortgage Loan payments do have a place in the world. In our opinion, at least, there are practical uses for borrowers to utilize an Interest-Only Mortgage Loans with Interest-Only payments. But none of them involve leveraging themselves into a larger mortgage, particularly one with an adjustable mortgage interest rate.

If a borrower could afford either a fully amortized or Interest-Only mortgage payment, under what circumstances might choosing an Interest-Only option provide any benefit

Accumulating Assets

If the Interest-Only mortgage payments are overlaid on a fixed rate mortgage loan product with a fixed period of 5 years, a borrower could invest the payment difference in a cash investment at an interest rate of perhaps 2% for the period. Over the 5 year fixed interest rate period, that regular stream of deposits would grow to a balance of $7,566. At the beginning of the 6th year, should the mortgage rate increase to 7% (and with a monthly payment term compression to 25 years, as described before), the $173 additional due in each monthly payment could be drawn from this subsidy account. This way, the borrower would have no monthly budget issues for a period of 44 months.

Of course, this is assuming just a 2% return over the time period. If a borrower could earn a higher return over that period, that subsidy could last longer. However, it's very likely that after the 6th year, the mortgage interest rate would again adjust (and a higher interest rate for the next year would certainly shorten the subsidy period).

Interest-Only Mortgage Loans - Money for College

Financial planners and investment counselors will tell you that perhaps the most important component of an investment is the term period which it has to compound its earnings. This can be especially true if you have young children whom you wish to send to college. The earlier that you can commit money to an investment plan, the more likely you will be able to reach your goals. After the Interest-Only period ends, of course, you might not have additional money to commit to this savings plan, but the money already committed will have a longer compounding period.

Interest-Only Mortgage Loans - Money for Retirement

Are you an older homeowner, and seeing retirement in the horizon? Have your children all grown and moved away; leaving you with a big home and no one to fill it, and you think you might sell it in just a few years? An Interest-Only Mortgage Loan payment scheme might work for you here, too. If you've been in your home for a while, your loan balance has decreased; refinance to a new mortgage, with a fresh 30 year loan term and Interest-Only mortgage payments, could free up a considerable amount of money each month to maximize your other investments.

Information on Interest Only Mortgage Loans can be found here.

Read here for more information on Interest Only Mortgage Loan Programs

The Seasonal Income Factor

Not everyone in the workforce brings home a regular paycheck. Those with seasonal income, or who get a sizable portion of their income from bonuses or other sporadic payments, might also benefit from the lower payments that an Interest-Only Mortgage Loan scheme can provide. This can also allow the borrower to make a smaller monthly payments when money is limited, then accelerate mortgage payments (including the principal) when money is not as limited. In this way, the borrower could end up with the best of both worlds.

As A Prepayment Vehicle (Accelerated Amortization)

Some mortgage lenders are pitching short term Interest-Only Mortgage Loans as a means of paying down your outstanding principal loan amount. Using this scenario, you send in more than just the minimum principle amount required to fully amortize the mortgage loan, a sizable amount more. Typically, this is offered to borrowers who qualify for the payments on a fixed rate mortgage loan, but are instead encouraged to take a short term Adjustable Rate Mortgage with its low rate and to make payments as though it were a fixed rate at a much higher interest rate.

This would seem to defeat the purpose of selecting an Interest-Only Mortgage Loan payment plan, but there's nothing wrong with it, the benefit actually comes from transitioning from a higher fixed rate, fixed payment amortized schedule to a lower adjustable rate, frequently recast amortization schedule.

You should also know that rates for some Interest-Only product are higher than their fully amortized counterparts, so if you're attracted to this idea, you might actually do better basing your prepayment strategy on an otherwise, identical fully amortized loan product.

The process of making a constant level payment isn't novel. Paying as though your mortgage loan's interest rate is 6% when only a 4% minimum payment is required, for example - and may actually work to your advantage, provided the market interest rates don't increase appreciably.

Still interested in Interest-Only Mortgage Loan payments?

With their typically lower than fixed interest rates, and coupled with Interest-Only payments, an Adjustable Rate Mortgage (especially a short-term adjustable rate mortgage) could represent a way to have the lowest possible monthly mortgage payment and still be able to own your own home. However, all that flexibility comes with the risks involved.

Some mortgage loan products, allow you to have your choice of a payment plan, including Interest-Only, fully amortized or accelerated-amortizing. These so-called Option Arm Mortgage Loans or Pick-A-Payment Mortgage Loans are gaining in popularity, as they allow you to determine how best to apply your budget to your mortgage.

If you are already a candidate for an Adjustable Rate Mortgage, and if you have college, retirement or investments that you need take care of, then consider adding Interest-Only payments to your Adjustable Rate Mortgage (or even taking an Interest First-style product) in order to more fully fund the other financial needs in your life. Maybe you've got a gambler's instincts, and want to bet that your homes value will increase more in the future, or that you can invest the money better elsewhere than paying down your mortgage principal balance. As far as maximizing your tax deductions, remember that not only is that vast majority of your payment already comprised of interest, but that only a fraction of every dollar in interest you spend is tax deductible.

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