What is an Interest-Only Mortgage?
An interest-only mortgage is one type of mortgage where the borrower (mortgagor) is required to pay only the interest on the loan for a specified period. The principal may be repaid in a lump sum at a specified date or in installments over time.
• An interest-only mortgage is one in which you make only interest payments for the first few years of the loan, as opposed to principal and interest payments.
• Interest only payments may be made for a predetermined time period, made available as an option, or made for the duration of the loan (mandating you pay it all back at the end).
• Interest-only mortgage loans are typically structured as, type of ARM (adjustable-rate mortgage).
• Although interest-only mortgages result in lower payments for a time, they also prevent the accumulation of equity and result in a significant increase in payments when the interest-only period expires.
A Guide to Interest Only Mortgages
The structure of interest-only mortgages can vary. Interest-only payments may be made for a specified period of time, may be offered as an option, or may be made for the entirety of the loan's term. With some mortgage lenders, the option to pay only interest may be restricted to a subset of borrowers.
Typically, interest only mortgages require only interest payments for a period of five, seven, or ten years. After that, the loan converts to a standard schedule, also known as a fully amortized basis, and the borrower's payments will increase to include both principal and interest.
Interest-only loans are typically structured as an interest-only adjustable rate mortgage (ARM) also known as Interest-only (ARM). For a certain number of years, known as the introductory period, you pay only interest at a fixed rate. Following the conclusion of the introductory period, the borrower will begin making principal and interest payments, and the interest rate will begin to fluctuate. For instance, if you obtain a "7/1 ARM," your initial period of interest-only payments will last seven years, and your interest rate will then adjust annually.
Fixed-rate, interest-only mortgages are uncommon; they are typically associated with 30-year mortgages.
The history of interest-only mortgages
Customers were able to borrow on an interest-only basis prior to the 2008 financial crisis, without demonstrating how they would repay the debt. After the credit crunch hit, it became apparent that hundreds of thousands of interest-only borrowers would struggle to repay their mortgages in the future.
Due to this, it is currently extremely difficult to borrow on an interest-only basis. Not all lenders offer interest-only loans, and those that do have stringent requirements, such as a sizable down payment and an approved method for repaying the principal at the end of the term.
The one exception is investment in rental property. Many landlords pay only the interest on their mortgages, which is generally accepted by lenders.
If you are unable to repay the borrowed amount at the end of the term, you will either need to obtain a new mortgage or sell the property to pay off your mortgage.
The Repayment of an Interest-Only Mortgage
At the conclusion of the term of an interest-only mortgage, the borrower has several options. After the interest-only term expires, some borrowers may choose to refinance their loan, which can result in new terms and potentially lower principal and interest payments. Other borrowers may choose to sell the mortgaged property in order to repay the loan. Nonetheless, some borrowers may choose to make a one-time, lump-sum payment when the loan is due, having saved money by not paying the principal during the loan's term.
Special Considerations for Interest-Only Mortgages
In certain circumstances, certain interest-only mortgages may include special provisions allowing the borrower to pay only the interest. For instance, a borrower may be able to pay only the interest portion of their loan if their home sustains significant damage and they are required to make a substantial maintenance payment. In some instances, the borrower may be required to pay only interest for the duration of the loan, requiring them to plan for a single lump sum payment.
Advantages and Disadvantages of Interest-Only Mortgage
Interest-only mortgages reduce a borrower's required monthly payment by omitting the principal portion of the payment. Home buyers benefit from increased cash flow and enhanced assistance with managing monthly expenses. An interest-only mortgage allows first-time home buyers to defer large payments until years in which they expect their income to be higher.
However, paying only interest does not contribute to the homeowner's equity in the property; only the repayment of principal debt does so. In addition, when principal is added to the monthly payment, the amount owed increases substantially. This could be problematic if it coincides with a financial setback, such as job loss, an unexpected medical emergency, etc.
Borrowers should estimate their anticipated future cash flow with caution to ensure they can meet larger monthly obligations and repay the loan when due. While interest-only mortgage loans can be advantageous for a variety of reasons, they may also increase the risk of default.
The Advantages of an interest-only loan
Some borrowers may benefit financially from interest-only loans because:
The initial monthly payments for the loans are usually lower:
Since you only make interest payments for the first few years, your monthly payments are typically lower than with other loans.
May help you afford more expensive home:
Due to the lower interest-only payments during the introductory period, you may be able to borrow more money.
Repayment can be faster than a conventional loan:
If extra payments are made on an interest-only loan, the lower principal may result in a lower monthly payment. Extra payments can reduce the principal on a conventional loan, but the monthly payments remain unchanged.
Possibility of a rise in your cash flow:
Reduced monthly payments can free up a few dollars in your budget.
Rates may be lower:
This type of mortgage is typically structured as an adjustable-rate loan, which could result in lower interest rates than a fixed-rate mortgage.
The disadvantages of interest-only loans
Borrowers taking out an interest-only loan may be taking a risk. Among the disadvantages of this type of loan are:
You’re not building the home equity:
Building equity is essential if you want your home's value to rise. With an interest-only mortgage, you do not build equity in your home until you begin making principal payments.
Existing equity gained from your payment can be lost:
If the value of your home declines, your equity from your down payment may be wiped out. Loss of equity can make refinancing difficult.
Low payments are temporary:
Low monthly payments for a brief period of time may sound appealing, but they do not eliminate the eventuality of repaying the full loan balance. Once the interest-only period expires, your monthly payments will increase substantially.
Interest rates can go up:
Typically, interest-only loans carry variable interest rates. If interest rates increase, so will the amount of mortgage interest you pay.
The difference between interest-only and repayment mortgages
There are two options for mortgage repayment:
• Repayment
• Interest-only
With a repayment mortgage, you repay a portion of the principal and interest each month. You are guaranteed to pay off the entire loan at the end of the term if you make all of your payments.
With an interest-only mortgage, only the loan's interest is paid. At the conclusion of the term, you will continue to owe the initial amount borrowed.
Payments compared
The primary advantage of paying only the interest on your mortgage is that your monthly payments will be significantly lower.
Suppose you borrow $200,000 at a 3% interest rate for 25 years on an interest-only basis.
• The monthly payment for an interest-only mortgage would be $500.
• If the mortgage is repaid on a repayment basis, the monthly payment is $948.
An interest-only mortgage can make a mortgage more affordable, but in this case you would still owe the lender $200,000 after 25 years. If you paid the mortgage on a repayment basis, you would owe the lender nothing at the end of the term and would own the property outright.
Repayment plans
Before lending money on an interest-only basis, your mortgage lender will require an approved repayment plan. Depending on the lender, acceptable repayment plans may include ISAs and stock market investments. Your lender is likely to conduct periodic reviews to ensure that your chosen repayment plan is on track to satisfy the obligation.
In the past, lenders would allow borrowers to rely on the possibility of a future windfall, such as an inheritance or bonus, but now only a small minority will accept such collateral.
What to do if you have interest-only mortgage
If you have an interest-only mortgage, you must be able to pay back the principal at the end of the term. There are several ways to ensure that this interest-only loan mortgage occurs:
• Make the switch to a repayment mortgage. This will result in an increase in your monthly payment, but your mortgage will be paid off in full at the end of the term.
• Contribute to an investment plan that can be utilized to repay the principal at the end of the term. A financial advisor will be able to recommend an appropriate plan.
• Make either lump-sum or recurring over payments on your mortgage (if your lender allows this).
• Remortgage to a better mortgage rate, switch to a repayment mortgage, and repay the loan over a longer term to reduce monthly payments.
Even if you have several years left on your interest-only mortgage, you should take action if you're concerned about repaying the principal balance. It is crucial to seek financial advice as soon as possible because the longer you wait, the fewer options you'll have.
Your home may be repossessed if you fall behind on your mortgage payments.
How to Calculate an Interest-Only Loan
An interest-only loan is a loan where the borrower is required to pay only the interest on the loan for a certain period of time, whether it be for a portion or the entire loan period (with the obligation to pay back the principal of the loan at the end of loan period).
How to Calculate Payments
During the interest-only period, payments will equal the interest rate per period multiplied by the total loan balance.
After the interest-only period, the calculation of the remaining principal payments is identical to that of a conventional loan. The formula used to determine the total loan payments is merely a rearranged version of the standard annuity formula. The revised formula appears below:
Where:
- PMT = The total payment each period
- PV = The present value of loan (loan amount)
- i = The period interest rate expressed as a decimal
- n = The number of loan payments
Example
Suppose that you obtain a $1,000,000 bank loan. The bank you're working with has offered you a five-year loan with a fixed interest rate of 5.0 percent, with an interest-only option for the first year. You decide to accept the interest-only option and to make monthly payments.
We can intuitively view this as a one-year interest-only loan, followed by a four-year loan that requires principal repayment. Due to the monthly payment schedule, the interest rate per period will be 0.05/12.
For the initial twelve months, you simply pay this monthly interest rate multiplied by the total loan amount. The initial twelve-month payments will be computed as follows:
Consequently, you will pay $4166.7 for the first twelve months. Now we must determine how to calculate monthly payments for the next four years.
For the next four years, we will calculate each monthly payment using the ordinary annuity formula. As the loan is worth $100,000, its present value is $1,000,000. The interest rate per month will be the same as stated previously: 0.05/12. The total number of mortgage payments is 48, or twelve per year for four years. Below is the calculation for the next 48 months of payments:
Thus, you will pay $4166.7 for the first twelve months and $2,3029.3 for the remaining sixty months.
Why to get an interest-only mortgage
If you want to keep your monthly housing costs low, an interest-only loan could be a good choice. Typical candidates for an interest-only mortgage are those who do not intend to own a home for the long term, such as frequent movers or those who are purchasing a home as a short-term investment.
Consider an interest-only loan if you're looking to purchase a second home. Some individuals who purchase a second home eventually make it their primary residence. If you are not yet permanently residing in the home, it may be convenient to make payments solely on the interest.
An interest-only loan may sound appealing to those who wish to keep their monthly payments low, but it can be more difficult to qualify for and is typically more accessible to those who have substantial savings, excellent credit, and a low debt-to-income ratio.
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