An “interest-only mortgage,” as the name implies, is a loan where the payments include only accrued interest – and no principal paydowns or amortization.
Such loans had an enormous stigma for years because interest-only (I/O) loans were far more common prior to the 2008 meltdown and because so many of the loans ended up in default after 2008.
This is why I was shocked to hear an acquaintance of mine tell me about the popularity of his I/O offerings at his non-QM/alternative lending mortgage bank recently – even though his rates are in the 4% to 5% range.
As a result, we did some research and some payment comparisons for a $1 million loan, with 25% down and excellent credit and reserves.
$1,000,000 @ 2.625% Fully Amortized:
$4,017 per month (30-Year Fixed)
$1,000,000 @ 3.125% I/O:
$2,604 per month (10/6 Year ARM; Fixed for 10 Years)
$1,000,000 @ 4.25% I/O:
$3,542 per month (Non-QM; 7/6 ARM)
The above rates are just estimates for “no points or low points” loans, based approximately on where the market was on Friday, and are shown primarily so readers can see how much lower I/O payments are (they should not be construed as advertisements).
Our best I/O loans for perfect borrowers have rates that are about 1/2 percent higher than the fully amortized 30-year rate we offer to similar borrowers.
The spread is a little less for non-QM (aka alternative financing or subprime) loans but there is still a premium to be paid for I/O.
It is also important to note that all of our I/O offerings come with Adjustable Rate Mortgages (ARMs) with 5, 7, or 10 year fixed periods, as opposed to 30-year fixed-rate mortgages.
So, when are interest-only loans a good idea?
Almost never IF – such a loan is the only way a buyer can afford a home.
Financing Is Short Term. If a buyer knows her financing will be short-term and simply wants to save money for other uses.
Income Situation Will Improve. If a buyer is certain her income will improve (via stock options or commissions, for example) but she needs a lower payment for now.
Lower Payment Desired. If a buyer just wants a lower payment even though she can afford a higher payment.
Even though I/O payments are much lower, borrowers should keep in mind that they are effectively paying more every year in total interest in exchange for an I/O loan.
This is because I/O rates are often about 1/2 percent higher, as I mention above. So, with a $1 million loan, borrowers will accrue $5,000 more every year in interest if they opt for I/O payments.
