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Interest Only Mortgage

Interest Only Mortgage Loans
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In today’s lending arena, there exist more mortgage options for consumers than ever before.  One of the most talked about types of loans is the “Interest-Only” mortgage.  This type of loan has soared in popularity, especially when mortgage interest rates start to rise.  However, many consumers choose interest-only, or avoid it for the wrong reasons or because of common misconceptions.  So, what is an interest-only mortgage, and who is it right for? 

Loan products commonly referred to as “interest-only” are mortgages that have a payment option to pay only the interest for a defined period of time.  Interest-only options can be attached to fixed rate or adjustable rate mortgages (ARM) or on option ARM’s.  The payment option lets you pay a minimum of just the interest due each month for a defined period of time, typically the first 10 years of the note.  After the period, the note will become fully amortized over the remanding term of the loan.

Here are some common misconceptions about an Interest Only Mortgage:

Myth: You never have to pay principal or you can’t pay down the principal balance.
Fact:  Interest-only payment options allow the borrower to make a minimum payment of    interest-only each month during the interest-only term of the loan.  After which time the loan will amortize (payments of principal and interest) over the remaining term of the loan causing the loan to be paid in full after the 30th year of the loan.  At any time during the term of the loan you can opt to make additional payments towards the principle balance of the loan.

Myth:  All interest-only loans are adjustable rate mortgages.
Fact:  Many interest-only loans are adjustable rate mortgages in which you take advantage of a lower interest rate that is fixed for a period of time after which time it adjusts.  The new rate will be based on a predetermined margin which is added to a published index such as the London Interbank Offered Rate (LIBOR) or the Monthly Treasuries Average (MTA).  There are also interest-only loans in which the interest rate is fixed for the life of the loan.

Myth:  If I never pay down the principal balance, I will never build equity in my home.
Fact:  Not always true; Homes in the U.S. have been appreciating on average at a rate of 6% per year and even higher in some areas.  So even if you don’t pay a dime on your home’s principal balance, you could still be building equity in your home through appreciation. 

Advantages of an interest-only mortgage:

The Interest-Only Mortgage offers (Greater Purchasing Potential);  Many home buyers such as young professionals who expect to see their income increase over the next few years opt to take advantage of interest-only loans.  These interest-only programs can help a borrower with a lower qualifying payment which will enable them to purchase more home while still giving them the security of a low fixed payment for a defined period of time.

Flexibility of Payment;  Interest-only loans provide the borrower the flexibility of making the minimum payment when they want to or a larger payment when they desire.  This is ideal for someone that has a fluctuating income such as a sales person or a self employed individual. 

Invest the difference;  Many investors choose to invest the savings that the interest-only payment provides.  If a borrower has investments that can earn higher yields than their interest rate, they can make cash flow off the difference.  Another example is a business owner that needs the cash flow or knows that it will earn a better return in their business.   Another strategy is to take the savings in payment each month and use it to reduce higher interest debt such as credit cards.     

Tax Advantage;  Some wealthy individuals who could pay off their home, choose not to because of the tax savings of the interest.  Interest-only is ideal for these individual because they can write off their entire mortgage payment while keeping their payments low for other investments.  

Payment responsive to principal reduction;  Unlike conventional mortgages where the payment is fixed for the term of the loan, an interest-only loan recalculates your payment after each additional principal payment.  To calculate your payment you simply multiply your principal balance times your interest rate and divide by 12.

Disadvantages of an interest-only mortgage:

Downside of Greater Purchasing Potential;  While interest-only can be perfect for a young professional or someone that is buying in a rapidly appreciating area, it can prove disastrous for someone who is on a fixed income or someone that buys in a flat or depreciating area and neglects to pay on the principal balance.  These scenarios can turn very ugly when rates adjust or the loan amortizes itself leading to possible foreclosure. 

Possibility of Payment Shock;  Even when a borrower chooses an interest-only loan that is fixed for 30 years, they face a very real possibility of payment shock if they hold onto their loan past the interest-only period.  If the borrower has not paid on the principal balance during this time, the new payment that will result from the lender amortizing the loan in order to have it paid by maturity will be substantially higher.  Many borrowers could get hit with a double whammy in this situation if they have an ARM at this point.  Of course while you can always opt to refinance before these changes take place, you will be subject to current market interest rates and qualification of your current financial situation.

Is interest-only right for you?  It could be… Interest-only loans can be extremely valuable financial tools for some individuals.  At the same time they can prove costly in others.  The best thing to do when considering an interest-only loan or any other mortgage product is to consult a mortgage professional.

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