Interest-Only Mortgages And Facts That You Need To Know

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"Term Compression" And Payment Risk

Using the same style of example, over laying an interest-only loan on to a fixed-rate mortgage, but this time limiting the payment of the interest-only to five years and the remaining twenty-five years will be fully amortized, this example will show you some dramatic differences as a result.

By fully-amortizing the mortgage, the payments are then based on the loan going to term in thirty-years. The example we gave above, that was based on $600, was a debt-leveraged loan with the borrowers spending all of the $600 on interest, exclusively, while the loan amount was $120,000. When five years have passed the interest-only period expires and the borrower still owes $120,000 at 6%.

At this point the borrower no longer has thirty-years to repay and is only left with twenty-five to return the outstanding balance. With all calculations now for repayment being applied to a shorter period of time, twenty-five years, there is a higher monthly payment due. It has gone from the interest-only payment of $600 per month to $773 for a fully amortized one. This is a 29% increase in the monthly payment due or $173, as opposed to a payment of $179,000 for a fully amortizing loan at 6%.

This example shows that over a five-year period the borrower would have spent $34,833 towards interest. The balance of the term, twenty-five years would have been an additional $114,949 for a total of $146,782 in interest costs. If the borrower had gotten a fully amortized Fixed Rate Mortgage for a full thirty-year term the total of the interest payments would have been $139,006, which is a savings of approximately $8,000 over the full term of thirty-years.

Market Risk 1

If you choose a situation where you are only paying back the interest and not building equity by eliminating the principal debt you must then rely on the market appreciating for you to actually own more of your home.

If we examine the property market throughout the country as a whole we will see that not since the time of the Depression have property prices substantially crashed all across the board. But that is a national average. What happens within each region, city, town or neighborhood can be a lot different and does fluctuate quite often.

Market Risk 2

Now if market prices actually due decline considerably during the holding period, and there was a low down payment made, you may find yourself having to sell your property for much less than what remains to be paid on the loan. Plus, you will now need to raise the cash to satisfy the balance due, the sales fees and any other charges.

If this had been a fully amortizing loan, as mentioned above, and there had been $8,000 paid in during the first five years you would have then had enough funds to pay most sales costs.

Interest Rate Risk

So far we have used only fixed interest rate examples. This is not really indicative of what most scenarios entail these days when you start talking about interest-only loans that feature a short fixed interest rate period; some feature adjustable rates, which can change each month.

We have also talked about term compression and its effect on payments, which causes them to rise above what they otherwise would be when the interest-only period ends. What's now ooking here is a recipe for a financial crisis if the compression repayment term is multiplied.

To further illustrate what we are referring to study this example: The interest-only borrower has been pleasantly making his $600 dollar monthlies for five years at a fixed-rate, but interest rates have been steadily climbing from a very low starting point. They are now back to "normal" around 7%. This means the monthly payment has soared over 49% to $848 per month. Then if you should find yourself at the end of the fixed-rate period with such similar high rates your rate could easily reach 9% or even greater numbers that will translate into a $1,000 +/- monthly payment.

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