Given accelerated price appreciation on real estate, in some geographical areas, Interest Only Mortgages are becoming popular. Though not generally used during the past 50 or so years by the traditional bank lending community, they were used in the 1920’s.
Interest Only Mortgages are mortgages where the borrower only pays interest on the mortgage. No principal repayment is made until the end of the loan term.
The term of the Interest Only payment period can be 5, 10, 15 or even 20 years.
Once the Interest Only payment period ends, principal payments begin, a balloon payment is due on the loan, the home is sold, or the balance is refinanced.
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Additionally, in most cases, the borrowers in Interest Only Mortgages have the option to pay off principal during the loan period, if they wish.
Lenders can make available many different types of Interest Only Mortgages with different terms. An Interest Only Mortgage can be fixed for a period of time then adjustable for a different period. Or, they can be fixed for the entire term or adjustable for the entire term of the loan. Each structure offered is dependent on the lender.
The rate of interest charged for Interest Only Adjustable Rate Mortgages periodically changes based on some interest related major recognized financial index standard.
The index used varies by lender but generally it’s the London Inter Bank Rate which is the rate available for banks on US Dollar denominate deposits in London (LIBOR), the Prime Rate, the Constant Maturity Treasuries (CMT) which are adjusted daily interest rates for a fixed maturity, One Year Treasury Bill Rate or the Cost Of Funds Index (COFI) which is a composite rate of savings, and other accounts at the Federal Home Loan Bank (FHLB). Lenders can and do use other indexes.
The rate of interest charged for Interest Only Adjustable Rate Mortgages can increase and decrease during the term of the loan.
The rate of interest charged for Interest Only Adjustable Rate Mortgages sometimes is capped at a certain maximum level which assures borrowers that the rate charged cannot be exceeded during the term of the loan. Additionally, other features can be included in Interest Only Adjustable Rate Mortgages, including: monthly payment caps for a specific term, assumability of loan for a new purchaser and a future convertibility option for giving the borrow the ability to convert from an Interest Only Mortgage to one that is fixed.
Generally, most relatively small borrowers historically have not used Interest Only Mortgages for their financing needs.
The major reason for selecting an Interest Only Mortgage versus a traditional Fixed Mortgage or Adjustable Rate Mortgage is that the monthly payments at least initially are normally considerably lower given typically lower short-term interest rates versus long term interest rates and given the non repayment of principal feature during the Interest Only period. This ”spread” in some cases can be several percentage points and can make a very substantial difference in the amount of the monthly payment due during the initial term of the Interest Only mortgage.
The rate charged borrowers on Interest Only Mortgages is typically based on current short-term interest rates coupled with a lender’s determination of the loan repayment capabilities of the borrower. Generally, this repayment capability is based on the borrower’s LIFO score (375 to 900), an evaluation of the borrower’s credit history and a grading of the loan from A to D. The higher the score the less the perceived repayment risk and consequently a lower interest rate is made available to the borrower.
Consequently, the cost of borrowing for similar loans with similar loan terms can vary substantially different between individual borrowers.
Interest Only Mortgages are offered through mortgage brokers and from direct lenders.
In addition to the rates listed above based on some index, the mortgage brokers and direct lenders can add some sort of margin, fees or additional costs to the interest rate index, this can take the form of “points” other fees, or a “spread”.
Potential users of this type of real estate financing product should: ask questions, check with several offering companies, take your time and compare product offering, and understand the product. Generally speaking Interest Only Mortgages are very complex sophisticated financial instruments and users of these types of financial instruments should be conversant with and understand the terms, conditions, tax consequences and other implications of using these products for their real estate mortgage needs.
