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interest only loan
I continue to be dumbfounded by the claims about interest-only loans reported to me by mortgage shoppers. Whether the claims originate with loan officers or, as one defensive loan officer suggested to me, they arise in the over-active imagination of shoppers who still believe in the tooth fairy, I canĄ¯t say for sure. Probably it is some combination of the two. All I know for sure is that misperceptions abound, and I keep running into more of them.
Misperception 1: Interest-only loans are a type of mortgage. They are not. Interest-only is an option that can be attached to any type of mortgage.
For example, a 30-year fixed rate mortgage of $100,000 at 6% has a monthly payment of $599.56. This is the fully amortizing payment -- the payment which, if maintained over the full term of the loan, will just pay it off.
In month 1, that payment divides into $500 of interest and $99.56 of principal. In month 2, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After 5 years the balance is $93,054. That is how mortgages amortize.
Now lets attach an interest-only option to this mortgage, available, say, for the first 5 years. That means that the borrower need pay only $500 a month during the first 5 years. There is no payment to principal.
If the borrower exercises the option, therefore, the balance after 5 years is $100,000. There is no amortization. Beginning year 6, the borrower must begin paying $644.31. That is the fully amortizing payment for a 6% loan of $100,000 for 25 years.
Misperception 2: It is less costly to amortize an interest-only loan. This is patently ridiculous, but some variant of it keeps popping up in my mail.
Suppose a borrower takes the mortgage described above with the interest-only option, but decides to pay $599.56. He doesnĄ¯t exercise the option but makes the fully amortizing payment instead. Then the loan will amortize just as it would have if the interest-only option had not been attached. After 5 years, the balance will be $93,054. If you make the same payment on the same mortgage, you end up in the same place.
If the borrower pays $700 a month instead of $599.56 on the same mortgage, the balance after 5 years will be $86,046. Whether the mortgage did nor did not have an interest-only option will matter not a whit.
Misperception 3. An interest-only loan carries a lower interest rate. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. But a lower rate would be irrational.
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