How Interest-only Loans Work

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.


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


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