Interest Only Mortgages

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An interest only loan (IO) mortgage allows you to pay only the interest charged for a stated period of time. This period can be anywhere from 1, 2, 3, 5, 7 or 10 years depending on the loan product type. The ensuing payment is typically 20% lower than a comparable 30 year mortgage. A higher than minimum payment will reduce the mortgage balance by the amount of the difference.

This old loan of the 1920’s, was brought back new as purchase prices rose beyond the normal qualifying of the 30 year fully amortizing fixed and the fear of the Great Depression faded. This interest only feature was added on after the hybrid ARM’s gained popularity and was a great alternative to the negative amortization adjustable rate mortgage.

The bottom line advantage of the IO over the other loans is it gets you in more home with less money yet mirrors the safety of the fixed rate.

It fits a lot of borrowers who know they will more than likely move on to another home within a certain period of time prior to the IO reset of interest rate.  Others found it the lesser of other evils, obtaining a lesser home with the financing they preferred or getting a riskier possible negative amortizing Option ARM adjustable. And, of course, there are those who don’t believe in paying down a loan at a low interest rate when the “house will skyrocket in value”.

The danger of hybrid ARM’s, especially interest only hybrids, is dealing with the worst case scenario: facing higher yet unknown future interest rates and a receding real estate market when the initial interest only period ends. Under these conditions, some experts believe such borrowers may face potentially payment shocks up to 30 to 70 percent once the initial period is over.

Most hybrid ARM’s have certain caps to protect the borrower against certain payment shocks and therein lies the shock or the safety. Hybrid ARM’s, including those with IO features, have an annual interest rate cap, a life cap and a first adjustment cap. The normal annual rate cap is approximately 2% above the certain interest rate. If you are at 5% now, the next maximum adjustable is 7%.

Here’s the rub: once your initial rate period ends, it falls under the first adjustment cap, not the annual rate cap, which is normally 5% to 6%, depending on the loan. Using the same example, that 5% could potentially, worse case, rise to 10% to 11% THE FIRST ADJUSTMENT. The loan will also fully amortize over the remaining period of time left on the loan. On a 5 year hybrid, that is 25 year remaining; 7 years, 23 years remaining – the shorter the time left, the higher the payment.

Reality check - we are nearly at the end of the rising of interest rates and conforming fixed rate loans are still below 6.5 percent.  Think about that - that is still historically low rates at 6 anything percent.

Without a mortgage plan and a good mortgage planner looking out for you, this could be a very scary situation. But let’s peel back the onion a bit. The scariest part is the worst case scenario coming true. There is nothing in keeping you from paying down principal with each monthly payment today to minimize the risk. The IO feature allows you to choose to or not choose to. Use self discipline and pay a little more each month.

Of course, over the last 20 years, a great mind set change has occurred and that is using your equity as opposed to paying it down. Few people today stay in the same home for 30 years. It is therefore indeed rare to have anyone payoff their mortgage these days until retirement.

Rather, many are refinancing to use “home cash” for buying other properties or investing, diversifying in other investments. Should the worst case scenario occur, refinancing to jump to another loan is a viable option to use instead.

The IO hybrid loan is very much like fire, a great thing when used wisely and bad when not given its due respect. Consider pre-planning your mortgage and you should be very warm and toasty in your new home!