Why Interest Only Loans Are Not Always Bad

Raziel Ungar

December 18th, 2011 - 2 min read

Since the financial meltdown, it seems that interest only loans have had a bad connotation and this loan type is one of the causes of what got us into this mess. If interest only is used to qualify a borrower who has a high qualifying debt to income ratio, coupled with a loan that has a prepayment penalty and is a short-term ARM (adjustable rate mortgage), it could be problematic, but by itself, interest only is not bad. The definition of interest only is a loan where the minimum payment made for a predetermined number of payments is just the interest and with that no principal is paid down, unless the borrower makes a payment greater than their minimum interest payment. But for the proper borrower it has it uses and can be a good fit; an interest only loan would be best for those with a low debt-to-income ratio, strong job tenure and good liquidity.

Interest only provides flexibility on monthly payment (allowing just interest to be paid instead of principal and interest) and also has inherent feature of ‘recasting’ whereby additional principal paid during in the interest only period will ‘recast’ the payment such that the next month interest only payment will be lower if principal is paid. For most fully amortizing loans the monthly payment is fixed and thus any additional payments to principal reduces the term (months remaining on the loan) and does not recast the subsequent monthly payment. Example:  if you have a 5% rate on $500,000 the interest only payment is $2,083 a month ($25,000 a year / 12 months). If you pay the loan down by $100,000 (one time) to $400,000 then the annual payment is $1,667 a month ($20,000 a year /12 months), which reduces the monthly payment by $416/mo. But if the loan if fully amortizing, then the $100,000 principal pay down will only shorten the term loan and the payments will still be $2,083/mo.

The most notable situation where interest only is useful is for borrowers who work in the financial services arena where 2/3 of their income is paid in bonus once a year and 1/3 is salary. In this situation borrowers pay interest only throughout the year whilst collecting their salary and when they receive their bonus, make a one-time pay down to the principal of their loan.  This causes the loan to automatically recast after the large principal pay down such that their interest only payment is lower in the following month because the principal has been reduced.

The other situation is if someone is receiving a large settlement or inheritance in a few years and they plan to apply all or a portion of the windfall to the principal balance of the loan and want the payment to recast, then interest only provides that option. This is similar to the example above but a one-time event versus an annual bonus event.

So, why do people not want interest only? In recent years with the financial problems, to qualify for interest only you need to have a lower debt to income ratio and be qualified as if fully amortizing the loan. Also, the rates for interest only are usually higher than those that are fully amortizing.  And finally, some borrowers do not have the financial discipline to make a payment great than the interest and want a fully amortized loan to keep them disciplined.

You need to see what fits your goals for the house and how long your plan to live there, and your income streams to help determine if interest only is right for you.

If you have questions about any of the above and you're thinking about Burlingame real estate, or real estate in nearby Hillsborough or San Mateo, contact Raziel Ungar, Burlingame Realtor, via the contact page.

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