Interest Only

Interest Only:

“Interest only” happens to be one of the more popular mortgage loan features available. The interest only, or I/O feature, allows the borrower to pay back only the interest that has accrued on the loan as opposed to a full principal and interest payment (think 30 yr fix loan).  Generally speaking, the “I/O” period is a set number of years.  Once the interest only period expires, the mortgage loan fully amortizes based on the remaining years left on the term. An example of this would be a 30 year term with an initial 5 yr interest only option.  After 5 years, the loan would recalculate and fully amortize the remaining balance over the next 25 years.

One advantage of this feature is the ability to make  lower monthly payments.  The result of this, however, is that your loan balance remains the same.  To offset this,  many homeowners opt to add money to their “I/O” payment on occasion for the specific purpose of paying down some of the principal of the mortgage balance.

Whatever the investment strategy, by not working down your loan balance, you are taking more risk, which is why Interest Only loans are typically more popular in appreciating markets.   It is important to understand the ramifications of what will happen to your particular loan when the interest only feature expires.

On a 30 year fixed with a 10 year interest only option for example, your rate will not change ever, but if you made the interest only payment for the entirety of that first ten years, when the interest only term expires and the loan re-amortizes itself, it will do so on a 20 year term which will make your monthly payments higher despite your interest rate remaining the same.  On Hybrid ARMs with an Interest Only feature this is also true, but to boot, the rate will adjust as well.  Interest only is more complex than most are willing to admit and should be fully understood before commitment.