An interest only mortgage loan is one where you don’t have to amortize the loan during the life-time of the loan. When the loan term is over, you must pay back the full principal as a lump sum. The payments that you make during the life-time of the loan are for interest only.
The classic mortgage loan doesn’t work like this. With a typical home mortgage loan, you will make a payment each month and part of that payment will be interest and part of it will be used to pay down the principal (amortization). The smaller the principal becomes, the less you have to pay interest on. This is true regardless of whether it is a fixed-rate mortgage (FRM) loan or an adjustable rate mortgage (ARM) loan.
With an interest only mortgage loan, the principal never gets smaller so you are paying interest on the borrowed amount throughout the life time of the loan. Example: You borrow $100,000 and pay 4% fixed-rate interest per year for 20 years. When the 20 years are over, you have paid $80,000 in interest and you must now pay back the $100,000 principal as a lump sum to the lender.
With a traditional mortgage loan where you pay interest + amortization, it would have worked differently. Example: You borrow $100,000 with a 4% annual fixed-rate. You also have a fixed amortization schedule where you amortize $5,000 at the end of each year, for 20 years. For the first year, the interest is $100,000 x 4% = $4,000. But you pay down the principal with $5,000 at the end of the first year, so for the second year, the interest is just $95,000 x 4% = $3,800. For the third, year, the interest is $90,000 x 4% = $3,600, and so on.
One reason why people opt for an interest only mortgage loan is to keep their monthly payments low, even if it means paying more in interest throughout the life of the loan. They don’t have to take so much money out of the monthly budget to pay for their home. Instead, they plan on paying the full principal back when they sell the house in the future.
Downsides with interest only mortgage loan
- You are paying more in interest throughout the lifetime of the loan, than you would for a loan where the principal was gradually amortized down.
- When the loan term is over, you must pay back the full principal to the lender as a lump sum. If you can’t come up with the money, the lender can force a sale of the mortgaged real estate.(Of course, if the real estate is still valuable enough and projected to not lose value, the lender will probably offer you a new mortgage loan instead, rather than go through the hassle of foreclosure, especially if you have a good credit history. They don’t mind you paying interest to them for another 20 years.)
- You are not building equity by amortization. If you sell your house before the mortgage term is up, a big chunk of the money you get will go directly to the lender to pay off the principal. If you had amortized, you would get to keep more money now.It should be noted that amortization isn’t the only way for equity to form. Equity is created not just by debt going down, but also by market value going up.
- There is always a risk that your house will not be worth enough to pay off the mortgage loan when it’s sold. Always check in advance if the interest-only mortgage loan you’re offered is non-recourse or not. If the loan isn’t non-recourse, you will be saddled with debt if your house doesn’t sell for a prize high enough to pay back the principal.Most lenders are unwilling to offer non-recourse interest-only mortgage loans, and those who do will typically charge a very high interest rate to compensate themselves for the increased risk. They are also likely to require a low loan-to-value ratio.