First, the good news: i/o loans increase house affordability by 20 percent. If you qualify for a $250,000 loan, you now can get $300,000; $300,000 becomes $360,000; and $400,000 becomes $480,000. In other words, you can qualify for a more expensive home than you would with a traditional mortgage. And the payments are dramatically different. On a five-year interest-only loan at 3.875%, your payment is $1,615. On a five-year hybrid at 3.750%, your payment jumps to $2,316. And on a 30-year fixed at 5.750%, your payment $2,918. Quite a difference there.
How interest-only loans work: Interest only loans do not prohibit you from paying down the principal balance. Most are available only with adjustable rate mortgages. Most are five, seven or ten year interest-only periods, where the rate is fixed. After the initial period, the rate can rise up to six percentage points. For instance, a 5/1 ARM rate is fixed for five years and the i/o may only be for five years, and the next 25 would be traditional principal plus interest—greatly increasing your payment. After the initial interest-only period, the loan becomes a fully amortized 30-year mortgage loan with no pre-payment penalty.
Now for the (potentially) bad news. The payment differences break down as follows over the life of a five-year interest-only ARM: Years one through five at 3.875%, your payment is $1,615. Years six through eight at 6.875%, your payment is $2,864. Years eight through ten at 9.875%, your payment is $4,114. Years 10 through 30 at 9.875%, your payment is $4,783. This last jump is due to the fact that during the last 20 years of the loan, the principal is spread out over 20 years as opposed to the traditional 30.
You may want an i/o if you: l Are disciplined with money l Are a risk taker l Aren’t taking on more than you can handle comfortably l Expect your income to rise sharply in the next five years l Have an irregular income (like commissioned sales) so that the lower payment is manageable during lean periods and when the money is coming in can pay down the principal l Are content to let rising markets build your equity for you l Are confident that home prices will continue to rise
You don’t if you: l Have a lot of consumer debt you can’t get a handle on l Plan on being in your house longer than the interest-only period l Are undisciplined with finances l Are borrowing a small amount l Plan on spending the extra cash on “discretionary” items l Plan to sell or refinance before the interest-only period ends l Want to lock in today’s low interest rates