Interest Only Mortgages – Get the Facts First

You see the ads “Interest rates as low as 1%”. Lured by these misleading promises consumers took out record numbers of Interest Only mortgages the past few years. Lately there has been a lot of negative press regarding Interest Only programs which further blurs the line between whether or not an Interest Only mortgage is right for you. This article addresses the “small print” and explains the different types of Interest Only mortgages so you will be armed with facts to know what questions to ask and make an informed decision.

Interest Only Example
As the name implies, with an Interest Only program you are only required to pay interest each month. A 6% rate on a $250,000 loan gives you an Interest Only payment of $1,250 compared to a Principal and Interest payment of $1,498.88. In this example, the difference of $248.88 is a fairly substantial amount. We will refer to this example throughout this article.

Fixed Payment vs Fixed Rate Interest Only
Before discussing the pros and cons of Interest Only programs, we first need to review some basics. Interest Only programs can be either a Fixed Payment Interest Only or a Fixed Rate Interest Only.

Fixed Payment Interest Only
You hear advertisements daily for Interest Only Fixed payment programs with appealing names like “Freedom Payments”, “Flexible Options” and “Smart Payments” with claims of amazingly low rates from 1% to 2%. Almost every mortgage banker/broker has access to these programs; the difference is in how they are explained to you. These programs seldom make sense and should be avoided in most cases.

The interest on Fixed Payment Interest Only programs usually changes every 1 to 3 months with minimum fixed payments that may be fixed from 1 – 5 years. Note the payment is fixed, but the interest rate is not fixed. In addition, they usually have prepayment penalties costing thousands of dollars if you sell or refinance your home within three years.

As the saying goes “there are no free lunches.” Although the interest rate changes every month, you have the “option” to pay the minimum fixed payment. When you receive your monthly mortgage statement, there are four payment options. Most people choose the minimum required payment.

Here is the catch. Often times the minimum payment does not even cover the interest. This is similar to your credit card statement that says you may skip a payment. You still owe the interest for that month which is then applied to your current balance so you are now paying interest on interest. In other words, your principal balance actually increases. Since there are very few exceptions when a Fixed Payment Interest Only program makes financial sense, we will not be reviewing the pros of these programs and instead we will focus on the Fixed Rate Interest Only programs.

Fixed Rate Interest Only
The most common Fixed Rate Interest Only programs are the 3/1, 5/1, 7/1 and 10/1 Adjustable Rate Mortgages (ARMs). The initial rate is fixed for the first 3-10 years respectively and cannot change during the initial period you choose. Therefore, if you think you will refinance or sell your home before the rate changes, from your stand point you have a fixed rate mortgage. Since you are taking some of the risk, the interest rate is typically a 1/4% to a 5/8% lower than the current 30 year fixed rates.

Cases when a Fixed Rate Interest Only Makes Sense
The top two reasons to consider Fixed Rate Interest Only programs are cash flow flexibility and more buying power. Cash flexibility is appealing if your income fluctuates from month to month, for example if you are commissioned or self employed. Since most Interest Only options allow you to prepay towards principal at anytime, you have the flexibility to make principal payments when your cash flow permits.

The second reason is increased buying power. Using the example at the beginning of this article, the Interest Only payment gives you an extra $50,000 in buying power. In other words, the Interest Only program allows you to borrow $300,000 and have the same payments as a Principal & Interest payment on a $250,000 mortgage. With the extra $50,000 in buying power, you may gain a needed 4th bedroom and the dream kitchen you always wanted.

Other reasons to choose an Interest Only program include better investment choices for the principal, an expected pay increase in the future, you already have significant equity, you are retired or retiring, or your household income decreased due to a divorce or illness.

Possible Negatives of an Interest Only
Besides never reducing the principal balance, there are other factors to seriously consider when deciding if an Interest Only program is right for you. An issue could arise if you put very little money down and unexpectedly need to sell your home after one or two years. If you did not apply any money to the principal mortgage balance and your home has not appreciated in value, you could find yourself “upside down” in equity and need to bring thousands of dollars to the closing table. Fortunately, most real estate markets have had sufficient appreciation over the past few years to cover any costs associated with selling a home, i.e. realtor commissions.

In general, the Interest Only rate will be 1/8% higher than the equivalent Principal & Interest rate. If you intend to pay principal each month and do not need the flexibility, you may as well go with a standard Principal and Interest program and take advantage of the lower rate.

Borrowers may have good intentions of applying money to the principal or diligently investing the difference, but what actually occurs may be less optimistic. If you are disciplined with your money and have a good savings history, the Interest Only may work for you. If on the other hand your saving skills are lacking, you may be better off with Principal and Interest payments which will act like a forced savings account by building up equity in your home.

Summary
The correct Interest Only program may enable better cash flow flexibility and allow you to afford a larger home or a better location. Before deciding if an Interest Only option is the best option, you need to consider your saving habits and review your future financial picture. Even more important, after deciding if an Interest Only mortgage is best for you, the biggest decision is choosing the most appropriate Interest Only program. A knowledgeable mortgage consultant can assist you with the pros and cons so you can make an informed and sound financial de