An interest-only loan is a loan in which for a set term the borrower pays only the
interest on the principal balance, with the
principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the
principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.
US interest only mortgages
In the United States, a five or ten year interest-only period is typical. After this
time, the principal balance is amortized for the remaining term. In other words,
if a borrower had a thirty-year mortgage loan and the first ten years were interest only,
at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The
practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This
gives the borrower more flexibility because he is not forced to make payments towards principal. Indeed, it also enables a
borrower who expects to increase his salary substantially over the course of the loan to borrow more than he would have otherwise
been able to afford, or investors to generate cashflow when they might not otherwise be able to. During the interest-only years
of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a
conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same
period of time that would be interest-only).
Interest-only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest
rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes
indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan
structures.[1] Because a homeowner does not build any
equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time he is either ready to
sell the house or refinance. He may find himself unable to afford the higher regularly amortized payments at the end of the
interest only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.
Due to the speculative aspects of relying on home appreciation which may or may not happen, many financial experts such as
Suze Orman advise against interest-only loans for which a borrower would not otherwise
qualify.[2]
UK interest only mortgages
Interest-only loans are popular ways of borrowing money to buy an asset that is unlikely to depreciate much and which can be
sold at the end of the loan to repay the capital. For example, second homes, or properties bought for letting to others. In the
United Kingdom in the 1980s and 1990s a popular way to buy a house was to combine an interest-only loan with an endowment policy, the combination being known as an endowment
mortgage. Homeowners were told that the endowment policy would cover the mortgage and provide a lump sum in addition. Many
of these endowment policies were poorly managed and failed to deliver the promised amounts, some of which did not even cover the
cost of the mortgage. This mis-selling, combined with the poor stock market performance of the late 1990s, has resulted in endowment mortgages becoming unpopular.
The property boom from the late 1990s has seen house price inflation far outstrip wage growth.
This has led to many lenders introducing a 'pure interest only' form of mortgage, one which
needs no proof of a repayment vehicle. By August 2007, it was estimated that 29% of first time
buyer loans were interest only leading to calls for caution from the mortgage sector.
"Although interest only mortgages play a vital part in the mortgage industry, often providing the only means for first time buyers to hold the key to their own front door, misusing this type of loan is counter-productive,"
said Moneynet.co.uk chief executive Richard Brown.[3]
Canadian interest only mortgages
Some interest-only mortgages in Canada allow the borrower to pay interest-only, principal and
interest, or even principal and interest plus 20% extra. An interest-only mortgage in Canada can be combined with corporate bonds
in a Registered Retirement Savings Plan (RRSP) where the plan holder
receives a tax deduction, tax deferral, and
compound interest.
From an investor's perspective
Interest-only loans are sometimes generated artificially from structured securities, particularly CMOs. A pool of securities (typically mortgages) is created, and divided into
tranches. The cashflows that are received from the underlying debts are spread through the
tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally
created in tandem with a principal only (PO) tranche. These tranches will cater to two particular types of investors, depending
on whether the investors are trying to increase their current yield (which they can get from an IO), or trying to reduce their
exposure to prepayments of the loans (which they can get from a PO).
Many homeowners saw the values of their homes increase by as much as 4 times its price in some markets in a 5 year span in the
early 2000s. Interest-only loans helped homeowners afford more home and earn more appreciation during this time period. However,
interest-only loans have contributed greatly to creating the current housing bubble situation, because many borrowers could not
afford the fully indexed rate. Interest-only loans may turn out to be bad financial decisions if housing prices drop, causing
those borrowers to carry a mortgage larger than the value of the house, which in turn will make it impossible to refinance the
house into a fixed-rate mortgage.[4]
Calculating an interest only payment
Calculating an interest only payment is very simple when compared to calculating an amortizing payment. When calculating for a
monthly interest only payment, one simply multiplies the monthly interest rate times the principal.
For example, the principal on a particular interest only loan is $10,000. The yearly interest rate is 6%. Therefore, the
monthly interest rate is 0.5%. (6/12 = 0.5) To calculate the payment, multiply the .5% or .005 X 10,000 which results in a
payment of $50.00. This payment is due each month. This seems like a steal, but when applied to the more typical numbers of a
mortgage, such as a $200,000 mortgage at 8% yearly, the interest only payment would be $1,333.33 each month. Then, when you
consider the payment on a mortgage with the same numbers amortizing over 30 years is $1,467.53, it doesn't look like the interest
only loan is such a great deal because it will never be paid. Interest Only Calculator
See also
References
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