Traditional mortgages require that borrowers pay back the money borrowed in the form of principal plus interest. As a result of these payments, the principal decreases over the term of the loan. At the opposite end of the spectrum are interest-only mortgages, which allow borrowers to pay only the interest accruing on the loan.Gustan Cho Associates
Payments On Interest Only Mortgages
An interest only mortgage is a mortgage loan program where the interest only is paid and not the principal. The payment that is required on interest only mortgages consists of only the interest for a specified period of the time, normally five years, seven years, or ten years. At the end of that specified time period, the mortgage loan balance remains the same and is not changed. When the period of the fixed term of the mortgage expires, the mortgage loan will re-amortize and both the principal and the interest of the mortgage loan are due. At that time, the mortgage loan is normally refinanced or a new mortgage loan can be undertaken.
Interest Only Mortgages: Basics
Under an interest-only mortgage, a borrower may choose to pay more than only the interest and have the additional money applied toward the principal. In fact, a borrower could choose to make the fully amortizing payment each month and retire the loan as though it had been structured as a conventional loan.
Because they are more risky than conventional mortgages, interest-only mortgages have strict qualifying standards. Lenders generally require that the borrower have at least a 30 percent equity in the property under finance and a minimum credit score of 720. Some lenders insist that interest-only borrowers have assets to cover as many as 24 months’ worth of principal, taxes, and insurance payments.
|The determination of a person’s ability to pay back an interest-only mortgage is based on the fully amortized payment, not the interest-only payment.|
Structure Of Interest Only Mortgages
Under an interest-only mortgage, the interest rate and monthly payment will change over the term of the loan. Monthly payments will likely increase even if interest rates stay the same. This is because, at the end of the interest-only term, the borrower is required to pay back the principal as well as the interest.
|ExamplePatrick takes out a 30-year mortgage with a five-year interest-only payment period. He pays only the interest for five years. At that time, both the principal and interest must be paid over the next 25 years. Because he is now paying back the principal in addition to the interest, his payments increase significantly beginning in the sixth year.|
Some lenders offer, in addition to interest-only and traditional principal and interest payments, a minimum or limited payment. This payment may be less than the amount of interest due in a particular month. Not only does the payment not pay down any principal, it also does not pay the full amount of interest. Any unpaid interest will be added to the principal. Increased principal results in a higher payment.
Interest Rates On Interest Only Mortgages
The interest rate on an interest-only mortgage is typically very low for the first few months, maybe 2 percent. After these first months, the rate usually rises to a rate closer to that of other mortgage loans.
Lenders terminate the option of interest-only payments when the amount of principal owed exceeds a certain limit, for example, 110 or 125 percent of the original mortgage amount. Most interest only mortgages are not issued by residential mortgage lenders. Commercial and portfolio mortgage lenders are lenders that offer interest only mortgages.