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What Is An Interest-Only Mortgage?
A mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make --consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want to.
If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged.
For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast, borrowers who have the same mortgage but without an IO option, would have to pay $615.72. This is the "fully amortizing payment" – the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is “principal”, which go to reduce the balance.
For a more complete illustration of the difference between an interest-only and a fully-amortizing mortgage, see Interest-Only Versus Fully Amortizing.
For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
Pay Principal When Convenient: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial payment to principal.
Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to. Buy More House: It is common for families to begin with a "starter house", then move into a more expensive house as their incomes rise. This process of "trading up" carries high transaction and moving costs.
You can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but the IO mortgage may make it manageable. Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize.
Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.