NOTE: FOR JUST THE CRITICAL FACTS ABOUT INTEREST-ONLY, SEE INTEREST-ONLY TUTORIAL.

July 24, 2000

"I am shopping for a mortgage and my financial advisor suggested that I consider an interest-only mortgage. What are the advantages of it, and for what type of borrower is it suitable?"

A mortgage is “interest only” if the monthly mortgage payment does not include any repayment of principal for some period. The payment consists of interest only. During that period, the loan balance remains unchanged.

For example, if a 30-year fixed-rate loan of $100,000 at 8.5% is interest only, the payment is .085/12 times $100,000, or $708.34. Otherwise, the payment would be $768.92. This is the “fully amortizing payment” – the payment that, if maintained over the term of the loan, will pay it off completely. The interest only loan thus reduces the monthly payment by 7.9%.

A loan that is interest-only for the full term would not amortize. The loan balance would be the same at term as it was at the outset. Back in the twenties, loans of this type were the norm. Borrowers typically refinanced at term, which worked fine so long as the house didn’t lose value and the borrower didn’t lose his job.

But the depression of the thirties caused a large proportion of these loans to go into foreclosure. Lenders stopped writing them and have never brought them back. They want loans that eventually amortize.

Hence, the interest only loans of today are interest only for a specified period, such as 5 years. At the end of that period, the payment is raised to the fully amortizing level. In such case, the new payment will be larger than it would have been if it had been fully amortizing at the outset.

Suppose, for example, the interest only period on the loan described above is 5 years. Then the payment starting in month 61 would be $805.23. To reduce the payment by $60.58 for the first 5 years, the borrower would pay an additional $36.31 for the next 25.

The longer the interest only period, the larger the new payment will be when the interest only period ends. If the same loan is interest only for 10 years, for example, the fully amortizing payment beginning in month 121 is $867.83. To reduce the payment by $60.58 for the first 10 years, the borrower would pay an additional $98.91 for the next 20.

Interest only mortgages are for borrowers who want a lower initial payment, and have some confidence that they will be able to deal with a payment increase in the future.