Interest Only Mortgages

Pay only interest and invest the difference.

Interest only mortgages have become very popular over the past few years. Whether you are a first time home buyer who wants to qualify for more house or a seasoned investor who has a better use for your extra cash, the interest only mortgage is a fantastic product.

There are many flavors of the interest only mortgage and many of these products are misunderstood and unnecessarily maligned. Our favorite product in this line is the

30 Year Fixed With 10 or 15 Year Interest Only Option
With this product, your rate is fixed for the entire 30 year life of the loan. However, your payment amount will change after the interest only period. Example: Say you took out a $100,000 loan at 6% interest on a 30 year fixed interest only loan with a 10 year interest only period. Your payment for the first 10 years would be $500 per month - and that is entirely interest. At the end of 10 years your loan balance will still be $100,000, and now the loan will automatically "recast" and become a 20 year fixed loan at 6%. Your principal and interest payment would then be $716.43 per month. After 20 years of making that payment, the loan would be paid off.

Had you chosen the 15 year interest only payment, it would work exactly the same way, except you would have the $500 payment for 15 years, then your payment would adjust to $843.86. After 15 years of making that payment, the loan would be paid off.

Hybrid ARM Interest Only - 3/1, 5/1, 7/1, 10/1
This product carries a fixed rate and an interest only payment for either 3, 5, 7, or 10 years. At the end of the fixed period, the loan recasts into an adjustable mortgage with a principal and interest payment. We only recommend this product to our clients who are confident that they will be in the loan for a shorter period of time than the adjustment period due to the payment shock that can be felt when the rate adjusts and the interest only payment period is over.

Pay Option ARM or Negative Amortization ARM
When you hear the negative press over interest only loans, this is generally the product that the press is complaining about, however, it is often mislabeled as simply an "interest only loan". This is a very sophisticated and complicated product that is right for only a few clients. Unfortunately, many loan officers will sell this product to clients who do not understand what they are getting into.

With the Pay Option ARM, typically the borrower is given an interest rate in the range of 1.5% principal and interest. This is the minimum payment that they are allowed to make. However, the actual "underlying"interest rate is variable, and is currently running in the 8% range on the typical Pay Option ARM. What that means is that if you make the minimum payment, that other 6.5% interest is being "deferred". What that means to you is that you are tapping the equity in your house every single month that you are making that minimum payment. Where this gets really dangerous is that typically there is a cap on the amount of equity that you are allowed to tap. Generally 115% of the appraised value at the time you took the loan out. It does not take very long to hit that cap, and when you do your payment can easily double or even triple over night.

Let's take an example. You take out a $100,000 loan at an underlying payment at 8.5%. For simplicity, let's just assume that 8% does not ever change, even though it is a variable rate. Your minimum payment is 1.5% principal and interest on a 30 year amortization schedule, which is $345 per month. $150 of that is interest and $195 is principal. Your interest only payment at the underlying 8.5% rate is $708.33. Therefore, each and every month you are tapping $363.33 worth of equity. That means that it will take $15,000 divided by $363.33 months to hit your "cap". That's only 41 months or slightly more than 3 years. So you happily make your $345 payment for those 3 years and you become very comfortable doing so. One day, you get a note from your lender indicating that you no longer have the "option" part of your pay option ARM, however. Now your loan has "recast" and your payment is now 8.5% principal and interest on a 30 year fixed amortization. And now your loan balance is $115,000 instead of the original $100,000. That's $884 per month, or 2.56 times higher than you made the previous month. Note that this situation gets worse when that underlying adjustable rate is steadily moving upward. Say that the rate went from 8.5% to 10.5% while you were making the minimum payment. That means that first, it took less than 41 months to hit the cap and second, your new payment when it adjusted was $1052 per month or over 3 times higher than your payment the previous month.