The Laurex Process: Strategy Development
Understanding Interest Only Fixed Loans
By Ted Bush

Although mortgage rates are lower than they have been in several years, there is still a way to get the payments even lower!!

What is an Interest Only Fixed Rate Loan?

These loans have a fixed rate for the full loan term (usually 30 years) but are designed so that the borrower pays interest only for a short period (usually 1,3,5,7, or 10Years), then the payment changes and are fixed for the remaining term on the loan. Interest only loans are loans on which the payments are for interest only and do not reduce the amount owed. They are usually Interest Only for relatively short periods of time, (1 to 10 years) and then become fully amortized over the rest of the loan.

How do they work?

The borrower pays interest only (no principal) for a period of time (usually 1-10years) then at the end of the no-principal period, the loan converts to a fully amortized mortgage and the monthly payments increase to cover both interest and principal. This not only reduces the monthly debts, but also improves the borrower’s credit rating.

What happens after the Interest Only Period?

Once the borrower passes through the “Interest Only” period, the payment amount will adjust to the then current rate and the loan will be totally amortized over the remaining life of the loan.  Some lenders will allow the borrower to convert to a fixed rate mortgage for the rest of the term. This is called a “Conversion Option’.

What are the benefits of this kind of loan?

• Borrower can get up to 100% Interest only for purchases, investment, or refinance.
• Borrower will usually get a much lower payment.
• Money is available to pay off other debt or make other improvements to the home.
• The borrower can purchase more home for less money because of the lower payment.
• Borrower only pays the Interest, not the Principal for a set period of time.
• This kind of loan often will free up cash to use somewhere else.

When would I want to use this kind of loan?

These kinds of loans are often desirable if:

• You feel that interest rates will decline in the near future.
• The borrower’s income is mostly in the form of infrequent commissions or bonuses.
• The borrower expects to earn substantially more in future years.
• You have a plan for investing the savings between the Interest Only payment and the fully amortized payment in an investment that will make money.
• The borrower is a business owner with an unpredictable income stream.

What are the traps with this kind of Loan?

One of the biggest concerns is once the interest only period is over, the payment increase substantially. Example: for a $400,000,25 yr loan @ 6.57%, interest only payment would be $2190/mo but the fully amortized payment would be $2718/mo. (a savings of $528/mo)

Another trap is the risk that the house may lose value instead of gaining value. This is particularly important when selling the home.

The borrower forgets that the payment amount will increase because of the new rate and the inclusion of principal into the payment.

What else should we know?

These loans may have a “Prepayment Penalty” for early payoff.

Another point to remember is that these kinds of loans typically do not help increase your net worth since you are not paying down the principal loan amount.

An example

Let’s assume someone borrows $200,000 at a fixed rate of 6.5%, paying only interest in the first five years. During those 5 years, the payment would be $1083 a month, plus taxes and insurance, with nothing contributed toward the homes equity. At the beginning of the 6^th year, the monthly payment—principal and interest—would rise to $1,350 in order to pay off the loan over the next 25 years.

By comparison, someone borrowing the same amount at the same rate, but paying principal and interest the entire time would have monthly payments of $1,264. After 5 years, the borrower would have accumulated almost $13,000 of equity.

Article Provided by:

Ted Bush
Capital Advantage