Interest Only Loans

Rating:  Adjustable Rate Interest Only:  High Risk

Description:  Interest Only loans have traditionally been popular with borrowers looking for the lowest available monthly payment. Investors looking to cash-flow a property are a common example of the type of borrower that may look for an interest only loan. These programs are no longer available for conventional Fannie Mae, Freddie Mac, FHA, or VA loans; as these agencies tightened credit guidelines in reaction to the housing crisis. They are most commonly seen through Foundation Mortgage portfolio loan programs, and through several Jumbo loan programs.  

An Interest Only loans are traditionally adjustable rate mortgages (ARMs) that consist of an initial interest only period in addition to an initial introductory fixed rate period.  When the initial interest only period ends, the loan is then amortized over the remaining years of the mortgage through principal and interest payments.  With an Interest Only loan, the borrower makes a reduced monthly payment over an initial period (Interest Only) at the expense of higher payments when the mortgage converts to principal and interest payments.  Typical loan terms for Interest Only Mortgages are 20 – 30 years.

How Do I Calculate My Payment on an Interest Only Loan?

Use the following formula to calculate the monthly payment on an interest only loan:

(Loan Amount  X  Interest Rate)  /  12.   

Example:   $400,000 Loan Amount with a 3.5% Interest Rate

($400,000 X 3%)/12 = $1,000.00 per month


Monthly Payment Adjustments for Interest Only ARMs

Adjustable Rate Interest Only Mortgages have two adjustment factors that impact your monthly payment.  It is important that you consider these two adjustable factors when determining whether an Interest Only loan is the best option for you.  

Adjustment to Interest Rate:  Similar to other Adjustable Rate Mortgages, the interest rate & monthly payment will adjust from time to time.   Click here to read more on how to calculate what your ARM payment will adjust to.

Adjustment to Fully Amortizing Monthly Payments: When the initial interest only period ends, your monthly payment will increase dramatically, even if your interest rate does not.  Playing catchup for not contributing principal at the outset of the loan can cause significant stress if you are not prepared for the increase in monthly payment when the loan converts to P&I payments.

Pros

  • Potentially lower initial monthly payment.

  • Minimum payment decreases as you pay down the principal.  

    • Since the monthly payment is based solely on the interest rate and loan amount, the minimum monthly payments decrease as you pay down the principal.  

    • Thus there is no recasting  fees as you pay down the principal.


Cons

  • Higher interest rates than comparable principal and interest fixed rate/ARM programs.  

  • If you keep the loan past the low initial interest only period, the monthly payment resets to a significantly higher monthly payment.  This usually results in a refinance and the additional costs associated with it.   

  • These products can entice consumers into taking out a loan which they can not afford.