Mortgage Forum

Zino

Interest only mortgage is exactly what is says... Simply put you only pay interest on the money you borrow and for the duration that your borrow the money. The interest only term can be very misleading in the sense that the idea of the original borrowing is not made clear.

For example, if you borrow $100,000 to buy a property. Your mortgage is for a 20 year period. As an interest only mortgage, assuming an interest rate of 5% ... your yearly interest charge on this amount is $5,000. Amortize that over 12 months; your monthly outgoing under the interest only scheme is $416.67.

Your total interest payments for the duration of the mortgage = $100,000.80 At the end of the mortgage period, you still owe the lender the original amount of money which you borrowed. Therefore, what appeared to be an attractive proposition at the outset does not look so good when you do the maths. This is the major draw back with interest only mortgages.

For the purposes of a comparison, consider the same amount of borrowing on a repayment basis:-

Assuming a borrowing of $100,000 over a 20 year period at an interest rate of 5%. Your initial monthly outgoings will be 2x$416.67 per month. Repayment scenario is much more expensive it would appear but you are reducing your capital slowly on a sliding scale. Your last monthly instalment gives you complete ownership of the property in question. Whereas the cheaper of the two mortgage options namely the interest only mortgage leaves you with a liability of $100,000 at the end of your mortgage term. This money has to be repaid as a lump sum to remove the legal charge by the lender which provides his security.

So, what kind of borrower should consider the interest only route?

Clearly, interest only route offers better prospects for short term borrowing. Plus, interest only route gives you access to more borrowing. Therefore, the kind of borrower that this mortgage suits is a developer rather than long term investor like a home buyer with a 20 year borrowing term as illustrated in this case scenario.

Information in the public domain suggests a preference for repayment mortgage over the cheaper alternative that is interest only mortgage. We decided to put that conclusion to a test by conducting a small survey.

1)Payment for a interest only mortgage is $416.67 per month.
2)Payment for a repayment mortgage is double that amount at $833.34 per month.

10 out of 10 people chose the interest only mortgage as their chosen mortgage. However, when we explained the implications of each mortgage in detail. 8 out of 10 people changed their original preference to the repayment one because repayment option offered them greater certainly in the long run. The remaining 2 people were asked why they chose to stick with their choice? Their response was that interest only mortgage offers us more leverage in the short term and it therefore suits our investment criteria.

Finally, home ownership is very long term commitment. Therefore, weighing up all the possibilities is very important. Such a strategy enables you to make your decision with all your information and options to hand. Better decisions are based on good and clear information.

I continue to be dumbfounded by the claims about interest-only loans reported to me by mortgage shoppers. Whether the claims originate with loan officers or, as one defensive loan officer suggested to me, they arise in the over-active imagination of shoppers who still believe in the tooth fairy, I can’t say for sure. Probably it is some combination of the two. All I know for sure is that misperceptions abound, and I keep running into more of them.

Misperception 1: Interest-only loans are a type of mortgage. They are not. Interest-only is an option that can be attached to any type of mortgage.

For example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly payment of $599.56. This is the fully amortizing payment -- the payment which, if maintained over the full term of the loan, will just pay it off.

In month 1, that payment divides into $500 of interest and $99.56 of principal. In month 2, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After 5 years the balance is $93,054. That is how mortgages amortize.

Now lets attach an interest-only option to this mortgage, available, say, for the first 5 years. That means that the borrower need pay only $500 a month during the first 5 years. There is no payment to principal.

If the borrower exercises the option, therefore, the balance after 5 years is $100,000. There is no amortization. Beginning year 6, the borrower must begin paying $644.31. That is the fully amortizing payment for a 6% loan of $100,000 for 25 years.

Misperception 2: It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.

Suppose a borrower takes the mortgage described above with the interest-only option, but decides to pay $599.56. He doesn’t exercise the option but makes the fully amortizing payment instead. Then the loan will amortize just as it would have if the interest-only option had not been attached. After 5 years, the balance will be $93,054. If you make the same payment on the same mortgage, you end up in the same place.

If the borrower pays $700 a month instead of $599.56 on the same mortgage, the balance after 5 years will be $86,046. Whether the mortgage did nor did not have an interest-only option will matter not a whit.

Misperception 3. An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.

The notion that interest-only loans have lower rates arises from comparisons of apples versus oranges. Adjustable rate mortgages (ARMs) with an interest-only option have lower rates than fixed-rate mortgages (FRMs) without an option. But an ARM with the option does not have a lower rate than the identical ARM without it.

Since the interest-only option is available on both FRMs and ARMs, it is pointless to be sucked into an ARM because of that feature. First choose whether or not you want an ARM or an FRM. This decision should be based on how long you intend to have the mortgage, and on your willingness to accept the risk of a future increase in the interest rate in order to have a lower rate in the short-term. If you opt for an ARM, then select the other ARM features you want, including an interest-only option.

Misperception 4. On an ARM with an interest-only option, the quoted interest rate is fixed for the interest-only period. This might or might not be the case. Where it is not the case, this may be the most dangerous misperception of all because it can induce borrowers to take ARMs that don’t meet their needs.

The interest-only period is the period during which you are allowed to pay interest only. The period for which the initial rate holds is a different matter altogether. On an ARM with a very low rate, the interest-only period is always longer than the initial rate period.

A common ARM today has an interest-only option for 10 years, but the initial rate holds only for 6 months. On a $100,000 loan with an initial rate of 4%, the interest-only payment is $333. If the rate after 6 months goes to 6%, the interest-only payment would jump to $500. Borrowers who thought they were safe for 10 years would get a rude awakening.

mariya08

Nice thread! I really like your provided information. It's really helpful for me.
Thanks a lot!

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