Useful Loan Information
Secrets Behind Interest Only Loans: Lower Payments, But Are They Right for You?
Author: Tony Baricevic
Interest Only loans gained widespread popularity in 2003 when FannieMae, the largest purchaser of secondary market home loans, provided guidelines to wholesalers for purchasing them. FannieMae calls it Interest First also known as Interest Only option. Until recently, this type of loan was common among seasoned investors who were looking for improved cash-flow allowing them higher profit margins and freeing up reinvestment capital. Interest Only options have also been available on 'negative amortization'* loans also known as Fixed-pay, Option ARM or Cash-flow ARMs among other names. However many Interest Only option loans like the FannieMae Interest First do not have negative amortization.
How Interest Only Loans Work: The loan can have an adjustable or fixed rate with an option to make the interest only payment for a predetermined period of time, say five years. Usually after that time, the loan payments become fully amortized and are recalculated to pay off the loan in the remaining 25 years. This can result in a significant increase in monthly payment if no principal has been paid down over the Interest Only option period, unless you refinance. The benefits of this loan are definitely cash-flow and it is also easier to qualify, since the payments are significantly lower. It can also be a good choice for people who are planning to sell their home in a few years, as they will have had a significantly lower payment while possibly taking a tax deduction of the mortgage interest. One risk involved would be if the value of the property decreased when it came time to sell and they didn't have enough funds to pay off the loan.
Some common Interest Only option loans are; Fixed 15/15 Interest First which has an Interest Only option for the first 15 years, or a Fixed 10/20 which has a 10-year Interest Only option and then gets amortized over the remaining 20 years. There are also adjustable loans like a 5/1 ARM with a 5-year Interest Only option or a 3/1 ARM with a 10-year Interest Only option and still many more variations.
Example: Here is an example of a 30-year Fixed Jumbo Loan with a 10/20 Interest Only Option: A $500,000 loan at 6% APR has a fully amortized monthly payment of $2998 which pays off the loan in 30 years. The Interest Only payment of $2500 is $498 lower per month. If you only paid $2500 each month for 10 years without paying down any principal, the fully amortized payment would adjust to $3582 in order to pay off the loan in the remaining 20 years.
Some people put the savings in payment towards common investments like stocks, bonds or mutual funds, hoping to earn money on the payments that they would have normally paid towards principal. People using this strategy on a primary residence would need to earn a higher rate of return than the interest that is being charged on the loan to stay ahead. This is because they would not be paying down the loan and their capital gains on the other investment may be taxed on withdrawal, so they would realize much less profit. Not to mention if they took a 'loss' on that investment, they would be paying more interest on their loan AND realizing a loss of their diverted investment capital.
Another important distinction is if they chose not to pay any principal or failed to invest the payment savings successfully when the Interest Only option period expired. Their payment would greatly increase unless they refinanced the loan at the prevailing future interest rates. In addition, having a higher loan to value ratio makes it more challenging to refinance.
Remember that the Interest Only option is just that, an option, and can be treated that way, only making the lower payments in times of hardship. A nice feature if it doesn't come at considerable added cost. Experienced investors can also leverage the lower payments to improve earnings. In summary Interest Only loans are all about cash flow, and flexibility. The new available fixed rate terms give them a welcome predictability, making it even easier for more people to qualify for a loan and own their very own home. Now you are "in the know".
* Negative Amortization is when a loan calculates a payment on a low fixed rate but uses an adjusting indexed rate to calculate the interest due. If this adjusting indexed rate payment is higher than the fixed payment, the extra interest is added on to the principal loan balance.
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About the author: Tony Baricevic is a Senior Loan Officer with Amerimac First Mortgage in Los Gatos, CA. His focus is on objective loan education and information. For a copy of The Top 10 Mistakes when Buying/Refinancing a Home go to http://www.quicloan.com
Article used with permission from author. Original rights are Tony Baricevic.