How Interest-only Loans Work

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 principal 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 principal would be $1,199.11. At first, payment against the principal is minimal. As time goes on, the interest gets paid down faster and larger chunks are applied toward the principal. In this case, the first payment of $1,199.11 has $1,000 applied to the interest and $199.11 to the principal. Every month, the loan is essentially recalculated. Since $199.11 was paid on the principal, you now owe $199,800.89. So in the second month, the amount that goes toward the principal 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 principal. Payments apply only to the interest. At the end of that five year period, you still owe the original principal 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.

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In the next section, we'll look at whether or not an interest-only loan option is right for you.

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The lower initial monthly payments of an interest-only loan are good for people who anticipate an increase in their income in the coming years. Having the option to pay as little as possible initially when you know a pay raise or promotion is on the horizon can be a real asset.

They're also beneficial for those who have fluctuating income. The IO loan option brings the flexibility to pay only the minimum payment during the lean months, or to pay extra when you have more disposable income. The extra payment is applied to the principal without penalty, lowering the amortized payment you'll be making once the IO period is up. If you have an IO loan, it's a good idea to chip away at the principal whenever you can. If you don't, you may suffer from "payment shock" once the loan is recalculated.

Another advantage to the IO option is that you're able to get more house than you could with an FRM. A common practice for first-time home buyers is to begin with a "starter" house, then sell it for profit after it appreciates. At this point they're able to get a larger second home. The lower initial term of an IO loan can allow you to skip the starter house and go directly to the larger house.

A homeowner that's wise in his or her investments might also benefit from an IO loan. Greater cash flow allows for more money available for playing the stock market or investing in other moneymaking opportunities. In order for this to be successful, the return on your other investments must be more than your mortgage rate. If you have an IO loan at 6 percent and your investments are coming back at 10 percent, you're doing the right thing.

Credit cards and other high-interest debts can be crippling for a family looking to get ahead. Applying the disposable income your IO loan provides toward that debt is a great way to achieve financial freedom.

An IO loan may also be a good idea if you plan on "flipping" your home within the option period for a return on your investment. Using sweat equity to restore an older home is a great way to maximize your profits. The one factor that's most important here is that your house appreciates during this time. For a while, real estate was appreciating rapidly in the United States and house flippers were getting rich. The bubble has burst somewhat now and appreciation in most markets has leveled out or declined.

With all of these examples, fiscal discipline is the most important factor in order to be successful. If you don't have enough self-control not to use your extra cash for that vacation in the Bahamas, then you aren't maximizing the benefits of your IO option. You may want to avoid an IO loan if:

It's important to do your homework and seek outside opinions from more than one financial adviser or mortgage broker. As with any commission-based industry, the integrity of your mortgage broker plays a vital role in the success of your plan. Some brokers will do anything to get you to sign on the dotted line. Do yourself a favor -- shop around, crunch the numbers and don't get carried away in the pursuit of your dream home.

For more information on interest-only loans, check out the links on the following page.