How Interest-only Loans Work


For sale signs in Antioch, Calif., a community hit hard by foreclosures when the housing bubble burst. Home prices here dropped 15 percent between May and October 2007. See more pictures of real estate.
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If you're reading this article from the comforts of your recently purchased home, you aren't alone. From 2001 to 2005, the United States saw the largest housing boom since the 1950s. Low interest rates coupled with new-found wealth from growing technology industries helped usher in a wave of home restoration and new construction [source: Chicago Fed]. Eager house hunters and investors bought and sold real estate like never before. Along with these factors, lenders used clever loans to allow just about any gainfully employed individual to realize their dream of owning a home. One such practice is the interest-only (IO) loan.

The first thing that's important to understand about home mortgages is the difference between the interest and the principal. Lenders give homebuyers the money to purchase a house for a fee that's spread out over the duration of the loan. This is the interest. The principle is the actual amount of the loan.

Many people assume that an interest-only loan is a type of mortgage. In fact, an IO loan is an option that can be attached to any type of home mortgage. The interest-only option means that the scheduled monthly mortgage payment applies only to the interest part of the loan -- not the principle. It's an option because you can pay a portion of the principle if you choose to without penalty. The IO option runs for a set period of time, typically five to 10 years.

Another common assumption is that the IO loan is a recent creation to help kick-start the post-Sept. 11 economy. While IO loans have certainly become very popular in recent years, they're far from new. The IO loan has actually been around for a long time, having its first heyday in the 1920s. In those days, lenders handed out IO loans that had no set term, allowing homeowners to pay only on the interest for the life of the loan. At the end of the loan, the full amount would be due, and borrowers would­ typically refinance. Americans were keen to invest as much money as possible in the rising stock market, and the IO loan freed up the cash to do so. What no one could predict was the market crash of 1929. Homeowners saw their investments vanish and suddenly couldn't afford to pay their monthly house note. As a result, the foreclosure rate soared and many once-stable families found themselves homeless. This had a devastating impact on the economy and, coupled with the market crash, led to The Great Depression [source: MSN Money].

Interest-only loans made a big comeback in the early part of the new millennium and continue to be very popular today, despite the leveling real estate market. In this article, we'll look at how IO loans compare to standard home mortgages. We'll also look at whether or not this type of loan option is right for you.

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Interest-only vs. Fixed-rate

Ben Bernanke, Chairman of the Federal Reserve Board, sets the prime rate for home mortgages.
Ben Bernanke, Chairman of the Federal Reserve Board, sets the prime rate for home mortgages.
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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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Choosing an Interest-only Loan

Some people invest in the stock market with the money they save from an IO loan.
Some people invest in the stock market with the money they save from an IO loan.
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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:

  • You aren't wise in your other investments.
  • Your income isn't expected to increase.
  • You aren't disciplined enough to pay on the principal.
  • Your home isn't expected to increase in value.
  • You feel the gamble on rising interest rates is not a good one.

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.

Finance Planning Tips

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Sources

  • "Consumer Handbook on Adjustable Rate Mortgages." federalreserve.gov, May 17, 2007. http://www.federalreserve.gov/pubs/arms/arms_english.htm
  • Fisher, Jonas D.M. and Quayyum, Saad. "The great turn-of-the-century housing boom." chicagofed.org, 2006. http://www.chicagofed.org/publications/economicperspectives/ep_3qtr2006_part3_fisher_quayyum.pdf
  • Guttentag, Jack. "Interest-only loans: not magic, usually not smart." msn.com, 2007. http://moneycentral.msn.com/content/Banking/­Homefinancing/P118084.asp
  • Kass, Benny L. "Interest-Only Borrowers Are Rolling the Dice." Washington Post, February 25, 2006. http://www.washingtonpost.com/wp-dyn/content/article/2006/02/24/­AR2006022400869.html

Finance Planning Tips

Here are some tips to help you with generating income and planning for the future.

Presented by United Way of Greater Atlanta Powered by SunTrust Foundation