What Is an Interest Only Payment?
- The way an interest only payment is structured, the borrower will make interest only payments for a certain amount of time, before then paying higher amounts so that the borrower starts to pay down the principal on the note as well. As an example, say "John" received at 3-year interest only mortgage. For the first three years John would pay just the interest on that mortgage when making his monthly payments. After that time, he would begin to make payments that paid the interest as well as the principal. Common interest only mortgage loans occur in 1-, 3-, 5-, 7- and even 10-year terms.
- Because the borrower is paying only the interest on the loan, the size of the loan payment is reduced during the interest only period. For example, this can be advantageous for a borrower who desires buy a larger house with a lower initial monthly mortgage payment. Using the example, say that "John" was purchasing a $400,000 home with 20 percent down and was receiving an interest only mortgage for the first three years on a 30 year fixed of 6 percent. His payments for the first three years of the loan would $1,600 per month. After the interest only period expires, his payments would be about $1,920 per month.
- For this mortgage product, the buyer pays a lower interest amount up front for a certain period of time. During this period they are only making interest payments on the balance of the loan. After the interest only period expires, the adjustable rate mortgage adjusts to a higher interest rate. Using the same example, if "John" purchased that same home, but had a adjustable interest only loan that was offering him 4 percent for the first three years, his initial payments would be around $1,067.00. If the interest rate then adjusted to 6.5 percent after three years his payments would be around $2,025. As a borrower with an adjustable interest rate product, you'd have to decide if the savings upfront was worth the higher rate down the line.
- In the case of a home loan, the interest only payment can allow you to buy "more house" with less money up front. It might also make sense if you're going to sell the home in a short amount of time because you feel values will increase, in essence flipping the home. And it also might make sense if you want to get used to paying a mortgage payment with something smaller, and then move to a bigger payment in a few years time when you feel you'll make more money, or will be more comfortable with the responsibility if paying.
- If property values decline, you won't have paid off any principal and may have zero equity or even be under water. If it is an adjustable product, the interest may adjust higher than you expected. When you got to sell the home, you don't have enough equity to cover the transaction costs of a real estate agent, or enough money for a downpayment on a new home.