Interest Only Loans
Interest Only Loan explanation
The interest only loan is the type of mortgage that lets you pay only the interest portion of your monthly payment for a fixed period of three, five, seven or ten years. The payment will not include any repayment of principal and the loan balance will remain unchanged.
After the end of the interest only period (3,5,7, and 10 years) the monthly payments readjust to include the principal, and the loan is re-amortized for the remaining years which can cause the payment to rise substantially. At this point, most people refinance, start paying off the principal, or sell their property).
Advantages of Interest Only Loan
- During the interest only term your monthly payments are as low as they can possibly get
- You can qualify for a larger loan amount, maybe even a larger home
- During the interest only term you won't pay out cash to build equity
- Make investments with payment difference to potentially build your net worth
- The entire monthly payment qualifies as tax-deductible interest during the interest only period
Interest Only Example
For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast, borrowers who have the same mortgage but without an Interest Only option, would have to pay $615.72. This is the "fully amortizing payment" - the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is "principal", which go to reduce the balance.
Below is the amortization table for the $100,000 loan example.
Interest only calculation: 100000 X 0.0625/12 = 520.83
Fully Amortizing Payment |
Interest Only Payment |
|||||||
|---|---|---|---|---|---|---|---|---|
Payment |
Interest |
Principle |
Balance |
Payment |
Interest |
Principle |
Blance |
|
| Month | First Year | |||||||
| 1 | 615.72 | 520.83 | 94.89 | 99,905 | 520.83 | 520.83 | 0 | 100,000 |
| 2 | 615.72 | 520.34 | 95.38 | 99,810 | 520.83 | 520.83 | 0 | 100,000 |
| 3 | 615.72 | 519.84 | 95.88 | 99,714 | 520.83 | 520.83 | 0 | 100,000 |
| 4 | 615.72 | 519.34 | 96.38 | 99,617 | 520.83 | 520.83 | 0 | 100,000 |
| 5 | 615.72 | 518.84 | 96.88 | 99,521 | 520.83 | 520.83 | 0 | 100,000 |
| 6 | 615.72 | 518.34 | 97.38 | 99,423 | 520.83 | 520.83 | 0 | 100,000 |
| 7 | 615.72 | 517.83 | 97.89 | 99,325 | 520.83 | 520.83 | 0 | 100,000 |
| 8 | 615.72 | 517.32 | 98.40 | 99,227 | 520.83 | 520.83 | 0 | 100,000 |
| 9 | 615.72 | 516.81 | 98.91 | 99,128 | 520.83 | 520.83 | 0 | 100,000 |
| 10 | 615.72 | 516.29 | 99.43 | 99,029 | 520.83 | 520.83 | 0 | 100,000 |
| 11 | 615.72 | 515.77 | 99.95 | 98,929 | 520.83 | 520.83 | 0 | 100,000 |
| 12 | 615.72 | 515.25 | 100.47 | 98,828 | 520.83 | 520.83 | 0 | 100,000 |
| Eleventh Year | ||||||||
| 121 | 615.72 | 438.74 | 176.98 | 84,060 | 730.93 | 520.83 | 210.10 | 99,790 |
At the end of the interest-only period, the payment is increased to $730.93. It is larger than the payment on the loan that was fully-amortizing from the beginning because it must pay off the loan over 20 years rather than 30.
Note that the example assumes that the interest rate is fixed over the entire life of these loans. Most interest-only loans, however, are adjustable rate, which means that the rate is very unlikely to be the same 10 years down the road.
