For a certain length of time, you can only pay interest on a home loan if it is an interest-only mortgage (IO mortgage). After that time, you have three options: refinance, pay the remaining amount in full at that time, or start making regular monthly payments. An interest-only mortgage has the advantage of allowing you to have low monthly payments for the first few years that you own the property, but it also has many disadvantages and is regarded as risky. This is all the information you require about how they operate and how to be eligible.
Interest-only mortgages have a reduced first monthly payment that only pays for the interest on the loan. Conventional loans, on the other hand, are amortized. A portion of the principal and interest are paid each month.
An interest-only mortgage is appealing because of its lower initial payment, which you can continue to make without having to pay any principal for up to ten years. However, the total interest paid will be higher, and since interest-only loans do not qualify as mortgages, there may be more stringent requirements to meet.
So, why would someone want to take out an interest-only mortgage? They could be hoping to raise additional funds before the interest-only period expires, selling, or refinancing in the near future, or they might have another investment opportunity and want to free up cash.
According to Mayer Dallal, managing director of non-qualified mortgage lender MBANC, it is feasible to purchase a property with an interest-only mortgage in the current market, sell it before any principal payments are due, and make money. “They can benefit from the capital appreciation in this way because home prices are rising,” he says.
How Interest-Only Mortgages Are Structured
In its most basic form, an interest-only mortgage is one in which principal and interest are paid after the first few years, usually five or ten, during which you only pay interest. It is not a condition of the loan if you choose to pay principal during the interest-only period.
Interest-only loans typically have the following structures: 3/1, 5/1, 7/1, or 10/1 adjustable-rate mortgages (ARMs). For adjustable-rate loans, the interest-only period typically corresponds to the fixed-rate period. For example, if you have a 10/1 ARM, you would only have to pay interest for the first 10 years.
With an interest-only ARM, the interest rate will change once a year (hence the “1”) based on a benchmark interest rate, such as the Fed Funds Rate or the Secured Overnight Financing Rate (SOFR), plus a margin set by the lender after the introductory period ends. The margin is fixed when you take out the loan, but the benchmark rate fluctuates with the market.
Rate caps limit Interest-rate changes. This is true of all ARMs, not just interest-only ARMs. The author of “The Loan Guide: How to Get the Best Possible Mortgage,” Casey Fleming, states that the initial interest rate cap on 3/1 ARMs and 5/1 ARMS is typically two. This implies that if your initial interest rate is 3%, when the interest-only period ends in either year four or year six, you will have earned a higher interest rate than 5%. In the case of %202007/1%20ARMs and %2010/1%20ARMs, the initial rate cap is typically 5%.
Following that, rate increases are typically restricted to 2% annually, regardless of the length of the ARM E2%80%99s introductory period. Lifetime caps are nearly always five percent higher than the loan’s initial interest rate, according to Fleming. Thus, in the event that your initial rate is 3%, it may rise to 5% in year eight, 7% in year nine, and maximum at 8% in year 2010.
You will be required to repay principal over the remaining loan term, or on a fully amortized basis as lenders refer to it, once the interest-only period expires. According to Fleming, balloon payments are not present in today’s interest-only loans, and in most cases, they are not even permitted by law. Thus, in year eight, your monthly payment for a 7/1 ARM with a 30-year full term and a seven-year interest-only period will be recalculated using the following two factors: the new interest rate and the principal repayment over the remaining 23 years.
Fixed-Rate Interest-Only Loans
Fixed-rate interest-only mortgages are not as common. You might pay interest only for ten years and interest plus principal for the final twenty years of a thirty-year fixed-rate interest-only loan. In year 11, your monthly payment would increase significantly if you made no principal payments during the first ten years. This is because you would start repaying principal after just ten years, as opposed to thirty. When the rate resets, your new interest payment is based on the total loan amount because you aren’t making principal payments during the interest-only period.
A $100,000 loan with a 3. 5% interest rate would cost just $291. 67 per month during the first 10 years, but $579. 96 per month during the remaining 20 years (almost double).
Over 30 years, the $100,000 loan would cost you $174,190. 80—calculated as ($291. 67 x 120 payments) + ($579. 96 x 240 payments). Had you obtained a loan with a 30-year fixed rate at the same three Using the 5% interest rate mentioned above, your total cost over the course of three years would be $161,656. 09. That’s $12,534. You don’t want to keep an interest-only loan for its entire term because you will pay an extra 71 in interest on the interest-only loan. If you choose to claim the mortgage interest tax deduction, however, your actual interest expense will be lower.
Are These Types of Loans Widely Available?
According to Yael Ishakis, vice president of FM Home Loans in Brooklyn, New York, banks are reluctant to offer interest-only loans these days since so many borrowers had problems with them during the housing bubble years. Y. , and the writer of “The Complete Guide to Buying a Home” “.
According to Fleming, the majority are large, variable-rate loans with set terms of five, seven, or ten years. A jumbo loan is a type of nonconforming loan. The main buyers of conforming mortgages, Fannie Mae and Freddie Mac, are government-sponsored enterprises; nonconforming loans, on the other hand, are typically not eligible to be sold to them, which is why conforming loans are more easily accessible.
Mortgage lenders have more money available for them to issue more loans when Fannie and Freddie purchase their loans. The secondary mortgage market for nonconforming loans, such as interest-only loans, is small, making it more difficult to find an investor willing to purchase them. Less money is available for lenders to make new loans since more of them hold onto these loans and handle them internally. Interest-only loans are therefore not as widely available. An interest-only loan is still regarded as nonconforming even though it isn’t a jumbo loan.
According to Fleming, “the best way to find a good interest-only lender is through a reputable broker with a good network, because it will take some serious shopping to find and compare offers.” This is because interest-only loans are less common than, say, 30-year fixed-rate loans.
Comparing the Costs
You should budget for at least a 0 percent interest rate increase for the interest-only feature, as rate increases vary by lender and day. 25% premium in the interest rate,” Fleming says.
Similarly, Whitney Fite, specialty lending, SVP at Capital City Home Loans, says the rate on an interest-only mortgage is roughly 0.125% to 0.375% higher than the rate for an amortizing fixed-rate loan or ARM, depending on the particulars.
When comparing a $100,000 interest-only loan to a fully amortizing ARM or a fixed-rate loan at an average interest rate for each loan type, the following is how your monthly payments would appear:
- 7-year, interest-only ARM, 3.125%: $260.42 monthly payment
- 30-year fixed-rate conventional loan (not interest-only), 3.625%: $456.05 monthly payment
- 7-year, fully amortizing ARM (30-year amortization), 2.875%: $414.89 monthly payment
You will pay $195 in the short term for an interest-only ARM at these rates. 63 monthly less than a 30-year fixed-rate loan for every $100,000 borrowed over the first seven years, and $154 47 monthly less than a fully amortizing 7/1 ARM
An adjustable-rate interest-only loan’s true lifetime cost cannot be determined at the time of purchase because you are unable to predict the interest rate at which it will reset annually. Fleming adds that while you can find the lifetime interest rate cap and the floor from your contract, there is no way to estimate the price. This would enable you to determine the lifetime cost minimum and maximum and determine that your actual cost would be in the middle. “It would be a huge range though,” Fleming says.
Tax Implications of Interest-Only Mortgages
There are several tax implications to consider with interest-only mortgages. First, in a number of countries, including the US, the interest paid on a mortgage loan may be tax deductible. Because of this, by deducting the interest portion of their interest-only mortgage payments from their taxable income, borrowers may be able to lower their overall tax obligation.
Secondly, one can claim a business expense deduction for the interest paid on an interest-only mortgage for an investment property. Additionally, this can help offset rental income and reduce the taxable income from the rental property. Note that obtaining these kinds of loans might be more challenging for a startup company.
Finally, by making smaller initial monthly payments during the interest-only term, borrowers may have more cash flow available for other goals like investing or starting a business. Owing to the increased liquidity, those operations might have opportunities for tax benefits. Investors might, for instance, use cash reserves to buy stocks until principal payments are due; this could lead to greater-than-normal capital gains or losses.
Are Interest-Only Mortgages Risky?
Risks associated with interest-only mortgages include the fact that borrowers do not accumulate equity during the first term and must make larger payments when switching to principal and interest payments. It’s critical to take into account both prospective interest rate fluctuations and long-term affordability.
Who Qualifies for an Interest-Only Mortgage?
Lender qualifying requirements differ, but generally speaking, borrowers must have excellent credit, make a sizable down payment, and be able to prove they have enough income to pay the mortgage’s increased payments in the future.
Can I Pay Principal During the Interest-Only Period?
Although some interest-only mortgages permit optional principal payments to be made during the interest-only period, it’s important to confirm this with the lender because the terms may change.
Can I Refinance an Interest-Only Mortgage?
It is possible to refinance an interest-only mortgage, but borrowers must meet the lender’s requirements and be eligible for a new loan given their current financial circumstances.
What Happens at the End of the Interest-Only Period?
Borrowers are required to begin making regular principal and interest payments upon the expiration of the interest-only period. Usually, the loan terms outline the transition, which could entail larger monthly payments.
The Bottom Line
Understanding interest-only mortgages can be difficult, and once the interest-only period expires, your payments will rise significantly. An ARM, which is a safe bet in an environment with low interest rates, will cause your payments on an interest-only loan to increase even more if interest rates rise. The best borrowers for these loans are those who are well-educated and fully aware of the risks involved. Article Sources: Investopedia mandates that authors cite original sources to bolster their claims. These consist of government data, original reporting, white papers, and conversations with professionals in the field. When appropriate, we also cite original research from other respectable publishers. You can read more about the guidelines we adhere to when creating impartial, truthful content in our
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FAQ
What is a main disadvantage of the interest-only loan?
The drawbacks of an interest-only loan include: You’re not creating equity in your house, which is something you should do if you want its value to rise. You won’t start to build equity in your house with an interest-only loan until you start making principal payments.
What is the point of an interest-only loan?
When circumstances warrant, borrowers can lower their interest payments with an interest-only mortgage. Additionally, property investors may be able to claim tax benefits*, as the entire interest repayment may be deductible from taxes.
How is an interest-only loan paid off?
You will be required to repay principal over the remaining loan term, or on a fully amortized basis as lenders refer to it, once the interest-only period expires. According to Fleming, balloon payments are not present in today’s interest-only loans, and in most cases, they are not even permitted by law.
Are interest-only loans a good idea?
Interest-only mortgages are chosen by borrowers for a number of reasons. They can purchase a larger home for less money with an interest-only mortgage. Additionally, it temporarily lowers their housing costs, maybe allowing them to make other investments.
Read More :
https://www.investopedia.com/articles/managing-wealth/042516/how-interestonly-mortgages-work.asp
https://www.consumerfinance.gov/ask-cfpb/what-is-an-interest-only-loan-en-101/