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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.
Most are jumbo, variable-rate loans with a fixed period of 5, 7 or 10 years. A jumbo loan is a type of nonconforming loan. Unlike conforming loans, noncomforming loans aren’t eligible to be sold to Fannie Mae and Freddie Mac, the two giant institutions that are the largest purchasers of conforming mortgages and a reason why conforming loans are so widely available.
When Fannie and Freddie buy loans from mortgage lenders, they make more money available for lenders to issue additional loans. Nonconforming loans like interest-only loans have a limited secondary mortgage market; it’s harder to find an investor who wants to buy them. More lenders hang on to these loans and service them in-house, which means they have less money to make additional loans. Interest-only loans are therefore not as widely available. Even if an interest-only loan is not a jumbo loan, it is still considered nonconforming.
Comparing the Costs
The rate increase for the interest-only feature varies by lender and by day, but figure that you will pay at least a 0.25% premium in the interest rate.
Rate on an interest-only mortgage is 0.125% to 0.375% higher than the rate for an amortizing fixed-rate loan or ARM, depending on the particulars.
Here’s how your monthly payments would look with a $100,000 interest-only loan compared with a fixed-rate loan or a fully amortizing ARM, each at a typical rate for that type of loan:
- 7-year, interest-only ARM, 3.125%: $260.42
- 30-year fixed-rate conventional loan (not interest-only), 3.625%: $456.05
- 7-year, fully amortizing ARM (30-year amortization), 2.875%: $414.89
At these rates, in the short term, an interest-only ARM will cost you $195.63 less per month per $100,000 borrowed for the first seven years compared with a 30-year fixed-rate loan, and $154.47 less per month compared with a fully amortizing 7/1 ARM.
It’s impossible to calculate the actual lifetime cost of an adjustable-rate interest only loan when you take it out because you can’t know in advance what the interest rate will reset to each year. There isn’t really a way to ballpark the cost, either, though you can determine the lifetime interest rate cap and the floor from your contract, so you could calculate the minimum and maximum lifetime cost, and know that your actual cost would fall somewhere in between.