How Do Interest-Only Mortgages Work?

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How Do Interest-Only Mortgages Work?

An interest-only mortgage may appeal to you if you desire a mortgage payment that is lower than what you can receive with a fixed-rate loan. You’ll have better monthly cash flow if you defer principal payments for a number of years at the beginning of your loan term.

However, what happens once the interest-only term expires? Who is providing these loans? And when is it wise to purchase one? Here is a brief overview of this mortgage kind.

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How Interest-Only Mortgages Are Structured

An interest-only mortgage, in its most basic form, is one in which you pay just interest for the first few years—typically five or 10—before starting to pay both principle and interest. Although it’s not required under the loan, you may pay principle during the interest-only term if you want to.

Interest-only loans are often arranged as 3/1, 5/1, 7/1, or 10/1 adjustable-rate mortgages (ARMs).For loans with adjustable rates, the interest-only term often corresponds to the fixed-rate period. For example, if you had a 10/1 ARM, you would only have to pay interest for the first 10 years.

The interest rate on an interest-only ARM will change once a year (thus the “1” in the name) after the conclusion of the introductory period based on a benchmark interest rate, such as the Fed Funds Rate or the secured overnight financing rate (SOFR), plus a margin decided by the lender. Although the margin is specified when you take out the loan, the benchmark rate fluctuates with the state of the market.

rates are capped. changes in interest rates. All ARMs, not only interest-only ARMs, are affected by this. According to Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage,” the initial interest rate maximum for 3/1 ARMs and 5/1 ARMS is typically two. In other words, if your initial interest rate is 3%, your new interest rate won’t rise over 5% after the interest-only term expires in years four or six. The initial rate limit for 7/1 and 10/1 ARMs is typically 5%.

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Regardless of how long the ARM’s introduction period lasted, rate hikes after that are typically capped at 2% per year. According to Fleming, lifetime limits are nearly always 5% higher than the loan’s initial interest rate. Therefore, if your beginning rate is 3%, it might rise to 5% in year 8, 7% in year 9, and 8% in year 10 before peaking.

After the interest-only period expires, you’ll have to begin paying back principle throughout the course of the remaining loan term—or, as the lender would say, on a fully-amortized basis. Today’s interest-only loans do not involve balloon payments; in fact, according to Fleming, they are often not even permitted by law. Therefore, in year eight, your monthly payment will be adjusted based on two factors: first, the increased interest rate, and second, the repayment of principle over the remaining 23 years if the complete term of a 7/1 ARM is 30 years and the interest-only period is seven years.

Fixed-Rate Interest-Only Loans

Interest-only fixed-rate mortgages are less frequent. You may pay interest only for the first 10 years of a 30-year fixed-rate interest-only loan before paying interest and principle for the next 20 years. Assuming you didn’t pay any principle during the first 10 years, your monthly payment would increase significantly in year 11 as a result of both starting to pay back principal and paying it off over 20 years rather than 30. When the rate resets, your new interest payment will be calculated based on the whole loan balance since you aren’t making principle payments during the interest-only period.

Over the first ten years of a $100,000 loan with a 3.5% interest rate, the monthly payment would be only $291.67; but, for the next twenty years, it would be $579.96. (almost double).

You would pay $174,190.80 for the $100,000 loan over 30 years, which is equal to ($291.67 x 120 payments) + ($579.96 x 240 payments). Your total cost over 30 years would be $161,656.09 if you had taken out a 30-year fixed-rate loan at the same interest rate of 3.5% (as was previously specified). You shouldn’t retain an interest-only loan for its entire duration since doing so would result in an extra $12,534.71 in interest payments. If you claim the mortgage interest tax deduction, however, your real interest expenditure will be lower.

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Are These Types of Loans Widely Available?

Banks are reluctant to issue interest-only loans now since so many borrowers had problems with them during the housing bubble years, according to Yael Ishakis, vice president of FM Home Loans in Brooklyn, New York, and author of “The Complete Guide to Purchasing a Home.”

According to Fleming, the majority are jumbo loans with variable rates and fixed terms of five, seven, or ten years. An example of a nonconforming loan is a jumbo loan. Nonconforming loans, in contrast to conforming loans, are often ineligible for sale to government-sponsored businesses, such as Fannie Mae and Freddie Mac, who buy the majority of conforming mortgages and are the reason why conforming loans are so readily accessible.

Mortgage lenders have more money available to them to provide new loans when Fannie and Freddie purchase their loans. Since there is a small secondary mortgage market for nonconforming loans like interest-only loans, it might be challenging to locate an investor willing to purchase them. Less money is available for lenders to issue new loans since more of them hold onto current loans and service them internally. Therefore, interest-only loans are less common. An interest-only loan is still regarded as nonconforming even if it is not a jumbo loan.

Since interest-only loans aren’t as common as, instance, 30-year fixed-rate loans, Fleming advises that “the best way to discover a solid interest-only lender is via a credible broker with a strong network, since it will require some serious shopping to find and evaluate offers.”

Comparing the Costs

According to Fleming, “the interest-only feature rate rise varies by lender and day, but assume that you will pay at least a 0.25 percent premium in the interest rate.”

The rate for an interest-only mortgage is around 0.125% to 0.375% more than the rate for an amortizing fixed-rate loan or ARM, depending on the specifics, according to Whitney Fite, specialized lending, SVP at Capital City Home Loans.

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With a $100,000 interest-only loan vs a fixed-rate loan or a fully amortizing ARM, each at a typical rate for that kind of loan, this is how your monthly payments would appear:

  • 3.125%, interest-only, 7-year ARM with a payment of $260.42 each month
  • 3.625% for a 30-year fixed-rate conventional loan with a regular payment of $456.05.
  • Fully amortizing ARM with a 7-year term and a 2.875% interest rate: $414.89 monthly payment

At these rates, a 30-year fixed-rate loan will cost you $195.63 less per month per $100,000 borrowed for the first seven years if you choose an interest-only ARM, and $154.47 less per month if you choose a 7/1 ARM that completely amortizes.

Since you cannot predict in advance what the interest rate will reset to each year, it is difficult to estimate the true lifetime cost of an adjustable-rate interest-only loan when you take it out. According to Fleming, there is no way to estimate the price, but you can find out your contract’s lifetime interest rate floor and maximum. This would enable you to estimate your lifetime costs’ lowest and maximum values and determine where their real values would fall. It would be a big range, adds Fleming.

The Bottom Line

Understanding interest-only mortgages may be difficult, and after the interest-only time is through, your payments will go up significantly. Your payments will rise even more if interest rates rise if your interest-only loan is an ARM, which is a safe bet in a low-rate market. The ideal customers for these loans are savvy consumers who thoroughly comprehend how they operate and the dangers involved.

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