Interest Only Loans
For years, these loans were made available by various savings institutions such as banks, savings and loan associations, credit unions and thrift associations. These institutions would make these loans and hold them until they became due, typically five years after origination. Because these institutions were forced to hold these loans for the duration of their term, they essentially lost liquidity and, as a result, the institutions charged an interest rate premium for these loans.
Recently, the mortgage industry has embraced this concept and has begun originating interest only loans and allowing these loans to be bought and sold in the secondary mortgage market. This has allowed these loans to become liquid and, as such, they have become more competitively priced, and, therefore, have lower interest rates.
How is this interest only mortgage different from the more traditional fully amortized mortgage? In a more traditional, fully-amortized mortgage, the borrower agrees to make a payment that includes both a principal reduction amount as well as the current interest due. When applied to the loan balance, the principal reduction amount decreases the loan balance and as the loan balances decreases so does the current interest due. Hence, while future payments are equal to the first payment, the distribution between principal reduction amount and current interest due is different. There is an inverse relationship between principle reduction and current interest due; as the principle reduction amount increases, current interest due decreases.
To better illustrate this inverse relationship, let’s assume a thirty year (360 months) fully-amortized loan amount of $300,000 with a fixed interest rate of 6.00% and a scheduled monthly payment of $1,798.65. Based on the number of payments made, the various principal and interest distributions would be as follows:
An interest-only loan with the same loan balance of $300,000 and a fixed interest rate of 6.00% would have a scheduled monthly payment of $1,500.00. A comparable chart to the one above would be as follows:
Opting for an interest-only loan rather than a fully amortized loan reduces your monthly payment, but fails to reduce your loan balance. While the above example is a thirty-year comparison, in essence the vast majority of interest-only mortgages are written with terms similar to terms for Intermediate ARMS, i.e., 3, 5, 7 & 10 years.
While the reduced monthly payment is enticing, there are some borrowers who opt for interest-only loans for a different reason. That reason being the borrower can qualify for a larger loan amount using an interest-only loan rather than the more conventional fully amortized loan. Expanding on the example above, a borrower who qualifies for a monthly mortgage payment of $1,798.65 could get a fully amortized loan amount of $300,000 or an interest-only loan amount of $359,730…this is nearly a 20% increase in loan amount by opting for an interest-only loan.