In the United States, a five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty year mortgage and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period or twenty years. The practical result is that the early repayments (in the interest-only period) are substantially lower than the later repayments. This enables a borrower who expects to increase their salary substantially over the course of the loan to borrow more than they would have otherwise been able to afford. The Interest only mortgage became popular in the 1920s. Due to the economic downturn and lack of work for the average person, there were many foreclosures during the Great Depression of the 1930s.

Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest only mortgage with an investment in the stock market, the combination being known as an endowment mortgage. The stock market crash of the late 1990s showed this to be a gamble. An interest-only mortgage in Canada can be combined with Corporate Bonds in a Registered Retirement Savings Plan (RRSP) where the plan holder receives a tax deduction, tax deferral, and compound interest.

Below are two distinct opinions about Interest Only Loans... One is a lenders sales pitch, the other is an article about Misperceptions... Read both, and call us if you have any questions.

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Sales Pitch for Interest Only Loan

Do you know anyone who wants lower monthly payments? They have a better chance today than has ever existed. Not only are interest rates at 40-year lows, but there is also a new mortgage-financing program that can lower payments even more. "Interest only" loans are now available.

Who's a candidate for this type of loan and what are the benefits? This loan is especially suited for individuals whose income varies from time to time (such as commissions, bonuses, or irregular payments). With "interest only," the obligation is to pay the interest portion of the loan, and pay principal when it is convenient. Paying principal is not required, but is recommended since reduction in a loan balance grows equity in a property.

Is principal reduction really necessary? Not for everyone. If the intention is to sell a property in a few years, principal reduction may not be recommended. In our area, we have generally enjoyed appreciation in property values; therefore, the property may become more valuable without reducing principal. "Interest only" loans eventually require payments of principal, but that varies from lender to lender. It is best to compare these requirements since the "interest only" period can vary from 1 to 10 years. The loan is typically a 30-year term loan, with a certain period of time where "interest only" payments can be made. Afterward the unpaid principal balance is amortized over the remaining term to include principal and interest sufficient to repay the loan in full.

This is one of the most aggressive mortgage financing tools to come along in a long time, and with today's low interest rates, the timing could not be better to help us all survive the downturn in our economy. It is also a great refinancing option for many people.

Misperceptions About Interest Only Loans

by Jack Guttentag 2004

Misperception 1: Interestonly loans are a type of mortgage. They are not. Interest only is an option that can be attached to any type of mortgage.

For example, a 30-year fixed rate mortgage of $ 100,000 at 6% has a monthly payment of $ 599.56. This is the fully amortizing payment -- the payment which, if maintained over the full term of the loan, will just pay it off.

In month 1, that payment divides into $ 500 of interest and $ 99.56 of principal. In month 2, the payment remains at $ 599.56 but the breakdown is $ 499.50 and $ 100.06. Each month, the interest portion declines and the principal portion rises. After 5 years the balance is $ 93,054. That is how mortgages amortize.

Now lets attach an interest-only option to this mortgage, available, say, for the first 5 years. That means that the borrower need pay only $ 500 a month during the first 5 years. There is no payment to principal.

If the borrower exercises the option, therefore, the balance after 5 years is $ 100,000. There is no amortization. Beginning year 6, the borrower must begin paying $ 644.31. That is the fully amortizing payment for a 6% loan of $ 100,000 for 25 years.

Misperception 2: It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.

Suppose a borrower takes the mortgage described above with the interest only financing option, but decides to pay $ 599.56. He doesn’t exercise the option but makes the fully amortizing payment instead. Then the loan will amortize just as it would have if the interest-only option had not been attached. After 5 years, the balance will be $ 93,054. If you make the same payment on the same mortgage, you end up in the same place.

If the borrower pays $ 700 a month instead of $ 599.56 on the same mortgage, the balance after 5 years will be $ 86,046. Whether the mortgage did nor did not have an interest-only option will matter not a whit.

Misperception 3: An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.

The notion that interest-only loans have lower rates arises from comparisons of apples versus oranges. Adjustable rate mortgages (ARMs) with an interest-only option have lower rates than fixed-rate mortgages (FRMs) without an option. But an ARM with the option does not have a lower rate than the identical ARM without it.

Since the interest-only option is available on both FRMs and ARMs, it is pointless to be sucked into an ARM because of that feature. First choose whether or not you want an ARM or an FRM. This decision should be based on how long you intend to have the mortgage, and on your willingness to accept the risk of a future increase in the interest rate in order to have a lower rate in the short-term. If you opt for an ARM, then select the other ARM features you want, including an interest-only option.

Misperception 4: On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. This might or might not be the case. Where it is not the case, this may be the most dangerous misperception of all because it can induce borrowers to take ARMs that don’t meet their needs.

The interest-only period is the period during which you are allowed to pay interest only. The period for which the initial rate holds is a different matter altogether. On an ARM with a very low rate, the interest-only period is always longer than the initial rate period.

A common ARM today has an interest-only option for 10 years, but the initial rate holds only for 6 months. On a $ 100,000 loan with an initial rate of 4%, the interest-only payment is $ 333. If the rate after 6 months goes to 6%, the interest-only payment would jump to $ 500. Borrowers who thought they were safe for 10 years would get a rude awakening.

Misperception 5: Interest-only loans are appropriate if you don't expect to be in the house very long. I don't know where this idea comes from, but it makes no sense. If you don't expect to have the mortgage very long it makes sense to select an ARM because the rate will be lower, and it makes sense to avoid paying points because there won't be much time to recover your investment through a lower rate. But the decision to take an interest-only should not be affected by your time horizon.

Misperception 6: Interest-only loans don't require PMI. Some loan officers are shameless in the stories they tell borrowers, and this is another one. Of course, some interest-only mortgages don't require PMI because the loan is too large relative to the borrower's equity, or the deal is otherwise sub-prime. In these cases, the borrower is paying the insurance in the interest rate.

If there is a loan that requires PMI but does not require it if the loan has an interest-only option attached, it would be because the insurer doesn't want the greater risk entailed by the PMI. In such case, the implicit insurance premium in the rate is bound to be larger than the PMI premium.

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