Interest-only vs. Fixed-rate
 Getty Image News Ben Bernanke, Chairman of the Federal Reserve Board, sets the prime rate for home mortgages. |
At first glance, the IO loan looks too good to be true. Monthly payments with an IO loan are substantially less than with a fixed-rate mortgage (FRM). However, it's important to understand that after the IO option period is over, the monthly note will increase -- sometimes substantially. FRMs have a set interest rate that's paid along with the principle over a long period of time.
To better understand how this works, let's take a specific look at how an IO loan might compare to an FRM:
If you borrowed $200,000 at 6 percent using a 30 year FRM, your total monthly payment for both the interest and principle would be $1,199.11. At first, payment against the principle is minimal. As time goes on, the interest gets paid down faster and larger chunks are applied toward the principle. In this case, the first payment of $1,199.11 has $1,000 applied to the interest and $199.11 to the principle. Every month, the loan is essentially recalculated. Since $199.11 was paid on the principle, you now owe $199,800.89. So in the second month, the amount that goes toward the principle is 6 percent of the new balance, divided by 12 [source: Washington Post]. This process of periodic payments spread over time is called amortization. At the end of the 30 years, your loan is paid in full.
An IO loan of the same amount at the same rate works differently. Let's say your IO option is set at five years with a fixed rate. The monthly payment during the five years is only $1,000, "saving" the borrower $199.11 per month. No portion of that goes toward the principle. Payments apply only to the interest. At the end of that five year period, you still owe the original principle amount of $200,000, but now it's amortized over 25 years at the current interest rate [source: Washington Post]. This will increase your monthly payment considerably. Add to this that not all IO loans have a fixed rate, and you can end up paying more per month sooner than you think. Some IO loan rates are fixed for as little as six months, something many borrowers overlook in their eagerness to get into the housing market.
| ARMs are risky for the buyer, because you're essentially gambling that the loan rate will decrease. Many first-time homebuyers decide to go with an ARM coupled with an IO loan option, as it can make for low initial payments. Many of those same borrowers find themselves between a rock and hard place once their payments balloon -- a factor in the increase of foreclosures in the United States [source: Federal Reserve]. |
In the next section, we'll look at whether or not an interest-only loan option is right for you.
