Advanced Wealth Builders
Interest Only Mortgage

 A mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make --consists of interest only. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want to.

If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged.

For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast, borrowers who have the same mortgage but without an IO option, would have to pay $615.72. This is the "fully amortizing payment" – the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is “principal”, which go to reduce the balance.

For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
Interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences.

Pay Principal When Convenient: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial payment to principal.

Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to.

Buy More House: It is common for families to begin with a "starter house", then move into a more expensive house as their incomes rise. This process of "trading up" carries high transaction and moving costs.

You can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but the IO mortgage may make it manageable.

Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize.

Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.

A valid example is the young borrower with a long time horizon who invests  in a diversified portfolio of common stock. This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return investing in their own businesses. 

Ask yourself whether you really will invest the excess cash flow, as opposed to spending it; and whether you have a firm basis for believing that your investments will yield a return higher than the mortgage rate. I don't recommend it as a wealth-building strategy for most borrowers.

Quick Capital Gain: An interest-only (IO) is the instrument of choice in a quick turnover situation if you are trying to maximize the amount of house you can buy, and are limited by your income. The IO option lowers the required initial payment, which allows you to qualify for a larger loan amount.

This is why buyers in markets undergoing strong price appreciation, who are looking for quick capital gains, gravitate to IOs – or to their big brother, the flexible payment (option ARM), which has even lower payments in the first year than an IO. The more expensive the house they can buy, the larger the expected capital gain. However, if you don’t need an IO to qualify for the house you want to buy, it is not the best choice in a quick turnover situation. Allocate Cash Flow to Second Mortgage: John Doe finances his home purchase with an 80% fixed-rate mortgage (FRM) at 5.5%, and a 20% HELOC at 7.75%. The FRM is IO, and Joe uses all his available cash flow to pay down the balance on the HELOC. This makes sense because of the higher rate on the HELOC, and the possibility of future rate increases.

Payment Responsive to Principal Reduction: On most IO loans, whether fixed or adjustable rate, the monthly mortgage payment will decline in the month following an extra payment. This is the only type of mortgage that has this feature. On a conventional FRM, the payment never changes while on ARMs, the payment doesn't change until the next rate adjustment.

Some borrowers find this feature extremely convenient. For example, a home purchaser who must close before his existing house is sold may want to use the proceeds of the sale, when it occurs, to reduce the payment on the new mortgage. On many but not all IOs, a large extra payment reduces the payment in the following month

On some IOs, however, the payment doesn't change until the anniversary month, and on others it does not change until the end of the IO period. If you are contemplating an interest-only loan and find immediate payment adjustments in response to extra payments a highly desirable feature, ask about it.