If you want a monthly payment on your mortgage that is lower than the amount you can get on a fixed-rate loan, you might be enticed by a mortgage with an interest rate premium. If you don't make principal payments for several years at the beginning of your loan term, you will have a better monthly cash flow. But what happens when the interest period is over? Who offers these loans? And when does it make sense to get one? Here's a quick guide to this type of mortgage.
How payments work
Basically, an interest-only mortgage is an interest payment for the first few years – usually 5 or 10 – and after that period you pay both principal and interest. If you want to make principal payments during the interest period, you can do so, but this is not a requirement for the loan.
Typically, you'll see interest-only loans structured as 3/1, 5/1, 7/1 or 10/1 adjustable-rate mortgages (ARMs). Lenders say choices 7/1 and 10/1 are most popular with borrowers. In general, the interest period is the same as the fixed-rate period for variable-rate loans. That is, if you have a 10/1 ARM, for example, you would only pay interest for the first 10 years.
In an interest-only ARM, the interest rate is adjusted once a year (this is where the "1" comes in) based on a reference rate such as LIBOR plus after the introductory period has expired. A margin set by the lender. The benchmark rate changes as the market changes, but the margin is predetermined at the time the loan is taken out.
Interest rate changes are limited by interest rate caps. This applies to all ARMs and not just ARMs that have interest only. The initial interest rate cap for 3/1 ARMs and 5/1 ARMS is usually two, says Casey Fleming, a loan officer at C2 Financial Corp in San Diego and author of Loan Guide: How to Get the Best Mortgage Possible. That is, if your initial interest rate is 3%, then your new interest rate will not be higher than 5% if the interest period ends only in the fourth or sixth year. For 7/1 ARMs and 10/1 ARMs, the initial rate limit is usually five.
After that, rate increases are typically capped at 2% per year, regardless of the ARM phase-in period. Lifetime caps are almost always 5% above the loan's starting interest rate, Fleming says. So if your starting rate is 3%, it could increase to 5% in year eight, 7% in year nine, and 8% in year 10.
Once the interest period ends, you must Begin repaying the principal over the remaining term of the loan (fully amortized, in foreign currency). Today's interest loans don't have balloon payments; they're usually not even allowed under law, Fleming says.So if the full term of a 7/1 ARM is 30 years and the interest period is only seven years, your monthly payment will be recalculated in the eighth year based on two factors: First, the new interest rate and second, principal repayment over the remaining 23 years.
A less common interest-only loan
Fixed-rate mortgages are not as common, although you can find them through Bank of America if you need a jumbo loan (a loan for an amount greater than $417 , 000) or through Navy Federal Credit Union for conforming loans (loans usually limited to $417, 000 in most parts of the country) and jumbo loans. To join the Navy FCU, you must be a member of the U.S. Armed Forces, Department of Defense, Coast Guard or National Guard, or be related to a Navy FCU member. (See Jumbo vs. Conventional mortgages: how they differ .)
With a 30-year fixed-rate interest loan, you may only pay interest for 10 years and then pay interest plus principal for the remaining 20 years. Assuming you did nothing against the principal during those first 10 years, your monthly payment would increase significantly in year 11, not only because you would begin repaying the principal, but because you would only be repaying the principal for 20 years, not 30 years. Since you don't repay the principal during the interest-only period, when the interest rate resets, your new interest payment is based on the entire loan amount. A $100, 000 loan with an interest rate of 3, 5% would cost only $291. 67 per month for the first 10 years, but $579. 96 per month during the remaining 20 years – almost double.
Over 30 years, the $100, 000 loan costs $174, 190. 80 (calculated as $ 291. 67 x 120 payments + $579. 96 x 240 payments). If you had taken out a 30-year fixed-rate loan at the same 3.5% interest rate (as mentioned above under "How Payments Work"), your total cost over 30 years would be 161.656 $. 09. That's $ 12, 534. 71 more interest on the interest-only loan, and these additional interest costs are why you don't want to keep an interest-only loan for its full term. However, your actual interest expense will be less if you deduct mortgage interest tax.
Loan availability
Because so many borrowers ran into trouble during the bubble years, banks are reluctant to offer the product today, says Yael Ishakis, vice president of First Meridian Mortgage in Brooklyn, NY, and author of The Complete Guide to Buying a Home.
Fleming says most are variable rate jumbo loans with a fixed term of 5, 7 or 10 years. A jumbo loan is a type of non-conforming loan. Unlike conforming loans, non-conforming loans can't be sold to Fannie Mae and Freddie Mac, the two major institutions that are the biggest buyers of conforming mortgages and one reason conforming loans are so prevalent.
When Fannie and Freddie buy loans from mortgage lenders, they make more money available so lenders can make additional loans.Non-conforming loans such as z. B. Rate lock loans have a limited secondary mortgage market; It's harder to find an investor willing to buy them. More lenders are hanging on to these loans and maintaining them in-house, which means they have less money to make additional loans. Interest rate loans are therefore not as widely available. Even if an interest-only loan is not a jumbo loan, it is still considered non-conforming. (Read more in Fannie Mae: What it does and how it works .)
Because interest loans aren't as widely available as, say, 30-year fixed-rate loans, " The best way to find a lender with good interest rates is a reputable broker with a good network, because it takes serious shopping around to find and compare offers, " Fleming says.
In addition to Bank of America, Navy FCU and the companies our expert sources work for-C2 Financial Corp, First Meridian Mortgage and Angel Oak Home Loans-we noted that EverBank, Union Bank's Private Bank, marketplace lender SoFi, Citizens Bank, Bank of Internet and United Wholesale Mortgage. This is not an exhaustive list, but it does provide a starting point if you are shopping for an interest-only loan.
Comparison of costs
"The rate increase for the" interest only "feature varies by lender and day, but expect to pay an interest rate of at least 0.25%, Fleming says.
Similarly, Whitney Fite, president of Angel Oak Home Loans in Atlanta, says the interest rate on an interest-only mortgage can be as low as 125% to 0.375% higher than the interest rate on an amortizing fixed-rate loan or ARM. depending on the details.
Here's what your monthly payments would look like with a $100,000 interest rate loan, compared to a fixed rate loan or a fully amortizing ARM, each with a typical interest rate for this type of loan:
- 7 years, interest-only ARM, 3. 125%: 260 $. 42
- 30-year fixed-rate conventional loan (non-interest bearing), 3. 625%: $456. 05
- 7 years, ARM fully amortized (30-year amortization), 2. 875%: 414 $. 89
At these rates, an ARM with an interest rate interest costs $195 in the short term. 63 less per month per $100,000 borrowed for the first seven years compared to a 30-year fixed-rate loan and $154. 47 Less per month compared to a fully amortizing 7/1 ARM.
It is impossible to calculate the actual lifetime cost of a variable rate loan when you take it out, as you cannot know in advance how the interest rate will reset each year. There's not really a way to get a handle on costs, Fleming says, although you can determine the lifetime cap and floor from your contract, so you can calculate the minimum and maximum lifetime costs and know that your actual costs would fall somewhere in between. "It would be a huge choice, though," Fleming says.
The Bottom Line
Mortgages with interest payments can be difficult to understand, and your payments will increase significantly once the interest period ends.If your interest-only loan is an ARM, your payments will increase even more if interest rates rise, which is a safe bet in today's low-interest rate environment. These loans are best for sophisticated borrowers who fully understand how they work and the risks they take. (For more information, see 5 Risky Mortgage Types to Avoid .)
You may also be interested in mortgages: Fixed-Rate versus Adjustable-Rate and Mortgage Basics .