The Mechanics of Interest Only Loan

Interest only loan can be a good option if you want a monthly payment on your mortgage that’s lower than what you can get on a fixed-rate loan. By not making principal payments for several years at the beginning of your loan term, you’ll have better monthly cash flow, but what happens when the interest-only period is up? When does it make sense to get one? Here is a short guide to this type of mortgage.

How the Interest Only Loan Payments Work

At its most basic, an interest-only mortgage is one where you only make interest payments for the first several years – typically 5 or 10 – and once that period ends, you pay both principal and interest. If you want to make principal payments during the interest-only period, you can, but that’s not a requirement of the loan.

You’ll usually see interest-only loans structured as 3/1, 5/1, 7/1 or 10/1 adjustable-rate mortgages (ARMs). Lenders say the 7/1 and 10/1 choices are most popular with borrowers. Generally, the interest-only period is equal to the fixed-rate period for adjustable-rate loans. That means if you have a 10/1 ARM, for instance, you would pay interest only for the first 10 years.

On an interest-only ARM, after the introductory period ends, the interest rate will adjust once a year (that’s where the “1” comes from) based on a benchmark interest rate such as LIBOR plus a margin determined by the lender. The benchmark rate changes as the market changes, but the margin is predetermined at the time you take out the loan.

Interest-rate changes are limited by rate caps. This is true of all ARMs, not just interest-only ARMs. The initial interest rate cap on 3/1 ARMs and 5/1 ARMS is usually two. That means if your starting interest rate is 3%, then, when the interest-only period ends in year four or year six, your new interest rate won’t be higher than 5%. On 7/1 ARMs and 10/1 ARMs the initial rate cap is usually five.

After that, rate increases are usually limited to 2% per year, regardless of what the ARM’s introductory period was. Lifetime caps are almost always 5% above the loan’s starting interest rate. So if your starting rate is 3%, it might increase to 5% in year eight, 7% in year nine and max out at 8% in year 10.

Once the interest-only period ends, you’ll have to start repaying principal over the rest of the loan term (on a fully amortized basis, in lender speak). Today’s interest-only loans do not have balloon payments. So if the full term of a 7/1 ARM is 30 years and the interest-only period is seven years, in year eight, your monthly payment will be recalculated based on two things: first, the new interest rate, and second, the repayment of principal over the remaining 23 years.

A Less Common Interest Only Loan

Fixed-rate interest only loan is not as common. With a 30-year fixed-rate interest only loan, you might pay interest only for 10 years, then pay interest plus principal for the remaining 20 years. Assuming you put nothing toward the principal during those first 10 years, your monthly payment would jump substantially in year 11, not only because you’d begin repaying principal, but because you’d be repaying principal over just 20 years instead of 30 years. Since you aren’t paying down principal during the interest-only period, when the rate resets, your new interest payment is based on the entire loan amount. A $100,000 loan with a 3.5% interest rate would cost just $291.67 per month during the first 10 years, but $579.96 per month during the remaining 20 years – almost double.

Over 30 years, the $100,000 loan would cost you $174,190.80 (calculated as $291.67 x 120 payments + $579.96 x 240 payments). If you’d taken out a 30-year fixed rate loan at the same 3.5% interest rate (mentioned in “How the Payments Work,” above), your total cost over 30 years would be $161,656.09. That’s $12,534.71 more in interest on the interest-only loan, and that additional interest cost is why you don’t want to keep an interest-only loan for its full term. Your actual interest expense will be less, however, if you take the mortgage interest tax deduction.