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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.
An Interest Only mortgage only requires monthly interest payments. Since you are not paying any principal, this can lower your monthly payment. However, since your mortgage's principal balance is not decreased, you will have a balloon payment at the end of the mortgage's term. Some Interest Only mortgages will also be adjustable rate mortgages (ARM). An Interest Only ARM will often have a period where the interest rate is fixed, and then it is adjusted annually. This calculator assumes that the interest rate for your Interest Only Mortgage remains fixed for the entire term.
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.
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.
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.
A valid example is the young borrower with a long time horizon who invests in a diversified portfolio of common stock. This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return investing in their own businesses.
Quick Capital Gain: An interest-only (IO) is the instrument of choice in a quick turnover situation if you are trying to maximize the amount of house you can buy, and are limited by your income. The IO option lowers the required initial payment, which allows you to qualify for a larger loan amount.