To answer this question, we must first examine interest only loans as compared to the best known and most poplular loan in the US, which is the 30 year fixed loan. 30 year fixed loans are structured to be paid off over a period of 30 years in 360 monthly payments. These loans are called fully amortized loans. For the purpose of this article, we will look at a loan of $200,000 and an interest rate of 6.125%. With this kind of loan, the principal and interest payment each month would be $1215.22. The first payment is broken down into a principal payment ( the part that pays off the loan ) of $194.39 and an interest payment of $1020.83. Each month gradually the payment moves toward paying off more principal and the amount of the interest becomes less because the balance of the loan is lower, thus reducing the amount of interest earned by the lender. When I say GRADUAL, I mean it. By the time a year has rolled around, the principal part of the loan has grown to a whopping $205.58. After 120 payments, or 10 years, the principal paid in the monthly payment has grown to only $356.27 and the interest is still $858.95. This loan is also popular with banks, and it is easy to see why. Over 30 years, this loan costs $437,479.20!

 

Interest only loans work differently. Keep in mind that generally, for a fixed rate interest only loan, the rate is generally .25% higher than a fully amortized loan, so that is the rate I will use, but we will still look at a $200,000 loan amount. For the first ten years, you have three payment options:

 

Interest only: $1062.50

Fully amortized: $1231.43

Principal and interest plus additional principal payments ( any amount over the fully amortized payment pays down additional principal and thus reduces the amount of interest accrued on the loan, thus accelerating the payoff of the loan ).

 

After the first 10 years, the loan recasts. This means that the balance of the loan is then amortized over 20 years, and there are then only 2 payment options:

 

Fully amortized payment: $1461.86 ( based on the balance of the loan amortized over 20 years )

Principal and interest plus additional principal payments ( which, again, would accelerate the payoff, same as above ).

 

Now, let’s look at the total cost of the fixed rate interest only loan. If no extra money is saved on the loan, and payments are made on schedule only, the total cost is $478,346. This is a cost of $40,866.80 more than the 30 year fixed loan. Why would anyone choose this loan? Several reasons. Better lifestyle for the first 10 years at a lower cost. To be able to qualify for or afford a home in a high cost area. But for wise consumers, the actual cost of this loan CAN be lower than the 30 year fixed loan.  For a consumer willing to invest the difference between the interest only payment and the fully amortized payment, the savings can be significant, especially in cases where a large tax deduction is needed. 

 

Are interest only loans risky? In the past interest only loans have been associated only with variable rate loans. For that reason many people think they are high risk. They are if used improperly. But with a carefully thought out financial plan, interest only loans can function as a financial tool and can be the most conservative mortgage. Conservative means to “conserve”, or to take the path most likely to save resources. By keeping payments low, investing the difference in a carefully chosen investment, depositing faithfully in that investment, the resulting tax savings and compilation of interest consistently provides cash to pay off the loan more quickly than a fully amortized loan would pay off. And nowadays there are two options with an interest only loan. Variable rates, commonly known as ARMs, have rates that are fixed for a set period, anywhere from 1 month to 10 years. After the initial period, the rate can rise or fall depending on the terms agreed upon. 30 year fixed rate interest only loans provide the option of a lower rate and payment for the first 10 years, with the security of a fixed rate for the term of the loan. 

 

The great thing about interest only loans as a financial tool is that it gives the borrower options. If used properly, the money usually locked into a home with a regular 30 year fixed loan will grow faster and can be used to pay off the loan sooner with the same amount of cash outlay. This is because of compound interest and tax savings. The money can be used for emergencies, and can give flexibility in case of illness, injury, death of the borrower. Also, banks are less likely to foreclose on properties with maximum financing. So homes that are highly mortgaged are less of a target for foreclosure than homes that have a lot of equity. At any time before the 10 year mark, money in that investment can also be used to pay down the loan, thus reducing the amount of the payment at recast if a lower payment is very important to the borrower.

 

Is an interest only loan right for you? For a free, no obligation consultation, call May Smith with Atlanta Mortgage Lending at 678-546-3040.