An interest-only loan is a loan in which for a set term the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.
Interest only mortgages
In the United States, a five or ten year interest-only period is typical. After this time, the principal balance is amortized for the remaining term. In other words, if a borrower had a thirty-year mortgage loan and the first ten years were interest only, at the end of the first ten years, the principal balance would be amortized for the remaining period of twenty years. The practical result is that the early payments (in the interest-only period) are substantially lower than the later payments. This gives the borrower more flexibility because he is not forced to make payments towards principal. Indeed, it also enables a borrower who expects to increase his salary substantially over the course of the loan to borrow more than he would have otherwise been able to afford, or investors to generate cash flow when they might not otherwise be able to. During the interest-only years of the mortgage, the loan balance will not decrease unless the borrower makes additional payments towards principal. Under a conventional amortizing mortgage, the portion of a payment that represents principal is very small in the early years (the same period of time that would be interest-only).
Interest-only loans represent a somewhat higher risk for lenders, and therefore are subject to a slightly higher interest rate. Combined with little or no down payment, the adjustable rate (ARM) variety of interest only mortgages are sometimes indicative of a buyer taking on too much risk- especially when that buyer is unlikely to qualify under more conservative loan structures. Because a homeowner does not build any equity in an interest-only loan he may be adversely affected by prevailing market conditions at the time he is either ready to sell the house or refinance. He may find himself unable to afford the higher regularly amortized payments at the end of the interest only period, unable to refinance due to lack of equity, and unable to sell if demand for housing has weakened.
From a lender’s perspective
Interest-only loans are sometimes generated artificially from structured securities, particularly CMOs. A pool of securities (typically mortgages) is created, and divided into tranches. The cash flows that are received from the underlying debts are spread through the tranches according to predefined rules, an Interest-only (IO) loan is one type of tranche that can be created, it is generally created in tandem with a principal only (PO) tranche. These tranches will cater to two particular types of investors, depending on whether the investors are trying to increase their current yield (which they can get from an IO), or trying to reduce their exposure to prepayments of the loans (which they can get from a PO).
Many homeowners saw the values of their homes increase by as much as 4 times its price in some markets in a 5 year span in the early 2000s. Interest-only loans helped homeowners afford more expensive homes and earn more appreciation during this time period. However, interest-only loans have contributed greatly to creating the subsequent housing bubble situation, because many borrowers could not afford the fully indexed rate. Interest-only loans may turn out to be bad financial decisions if housing prices drop, causing those borrowers to carry a mortgage larger than the value of the house, which in turn will make it impossible to refinance the house into a fixed-rate mortgage.
Calculating an interest only payment
Calculating an interest only payment is very simple when compared to calculating an amortizing payment. When calculating for a monthly interest only payment, one simply multiplies the monthly interest rate times the principal.
For example, the principal on a particular interest only loan is $10,000. The yearly interest rate is 6%. Therefore, the monthly interest rate is 0.5%. (6/12 = 0.5) To calculate the payment, multiply the .5% or .005 X 10,000 which results in a payment of $50.00. This payment is due each month. This seems like a steal, but when applied to the more typical numbers of a mortgage, such as a $200,000 mortgage at 8% yearly, the interest only payment would be $1,333.33 each month. Then, when you consider the payment on a mortgage with the same numbers amortizing over 30 years is $1,467.53, it may not look like the interest only loan is such a great deal because no principal is paid during those first number of years. While some may take those monies saved by doing an IO loan and put them to better use than just paying down your mortgage it can also be argued that this amount will go to less than efficient items. (I.e. more liabilities)