Interest Only Mortgages – The Complete Story

There has been a lot of attention given to Interest Only (IO) Mortgages recently. On the surface they seem like an attractive way to reduce your monthly mortgage payments without taking on the risk of an Adjustable Rate Mortgage (ARM). Is this as safe a path as it seems or is there a cost involved that is being brushed over? Let’s look at what really happens when you chose an IO Mortgage in today’s market.

To begin with, have you wondered why IO Mortgages are being offered now? Wouldn’t a product like this be more attractive in a higher rate environment such as we were in 5 years ago? In order to see why, we are going to need to examine the details of what happens when mortgage payments are made. When you take out a 30-year fixed rate mortgage you make the same mortgage payment every month for 30 years. Each payment you make consists of 2 parts. The first part pays for the use of the money for the month (the interest) and the second part is a payment made to reduce the amount you owe to the lender (the principal). The first payment is mostly interest and the last payment is mostly principal. The formula used to determine the monthly payment is one that would interest a mathematician but is of little interest to the rest of us. What’s important for us to recognize is that the amount of principal that is paid off each month is not only dependant on what payment is being made (the second mortgage payment pays a little less interest and a little more principal than the first payment and so on) but is also influenced by what the interest rate of the mortgage is.

For example, $100,000 borrowed for 30 years @ 6.0% interest requires a monthly payment of $599.55. The first payment consists of an interest payment of $500.00 (.06/12 x $100,000) and a payment towards principal of $99.55 ($599.55 - $500.00). When the second payment is due we now owe the lender interest on $99,900.45 ($100,000 - $99.55). So the interest payment in reduced to $499.50 (.06/12 x $99,900.45) and as a result the principal is decrease a little bit more. This pattern will continue for 360 payments (30 years) bringing the principal balance to $0.00. Now let’s see what happens when we use an 8.0% interest. The payment increases to $733.76 per month. Let’s repeat the calculation for the interest vs. principal for the first payment. The interest payment works out to be $666.67 (.08/12 x $100,000) and the reduction in principal is now $67.09 ($733.76 – $666.67). With a 2% higher interest rate we are starting off by paying $32.46 less in principal reduction, a 33% reduction. Both the 6.0% and the 8.0% mortgage will have an outstanding principal balance of $0.00 at the end of the term but the pattern of the principal pay down month to month will be different.

In order for an IO Mortgage to yield a noticeable saving in the monthly payment it needs to be at a low interest rate. If interest rates were at 10.0% the principal reduction due to the first payment works out to be only  $44.24. So, the answer to the question, why did it take so long for IO Mortgages to be promoted by the industry is simply that there wasn’t enough being paid towards principal when the rates were higher to be able to generate any saving in monthly payments for a borrower.

This leads us into the next question. What is the real cost of using an IO Mortgage? The first, and most obvious expense is that IO Mortgages will carry a higher interest rate then the standard fixed rate mortgage. You can expect to pay an additional 0.25% in the interest rate when the IO option is chosen on a mortgage. $100,000 borrowed for 30 years @ 6.0% interest requires a monthly payment of $599.55. Take this same mortgage and make it IO; the interest rate now increases to 6.25% and IO payment is $520.83 per month. A monthly saving of $78.72. Someone looking to place an applicant in an IO Mortgage will end the discussion at this point, leaving the applicant comfortable that he is saving $78.72 per month by using this type of financing.

Let’s take a closer look and see exactly what’s happening. With the IO Mortgage after 12 months we’ve paid out $6,249.96 ($520.83 x 12) and still owe the lender $100,000. With the standard 30-year fixed we paid out $7,194.60 ($599.55 x 12) but we’ve reduced what we owe the lender by $1,228.00. Comparing these two mortgages after the first year we see that we may have paid out $944.64 ($7,194.60 - $6,249.96) less by using the IO Mortgage but by not paying off any principal we actually lost $283.36 ($1,228.00 - $944.64) in net worth in that first year.

Since it’s not likely that you would be staying in this mortgage for only 1 year, lets take a longer time period, say 5 years. If you were planning to pay off this mortgage in 1 year then an ARM would have been the better choice so it is reasonable for us to go 5 years out.  With the IO Mortgage after 60 months (5 years) we’ve paid out $31,249.80 ($520.83 x 60) and still owe the lender $100,000. With the standard 30-year fixed we paid out $35,973.00 ($599.55 x 60) but we’ve reduced what we owe the lender by $6,945.63 leaving an outstanding balance of $93,054.37. Now when we compare these two mortgages we see that we may have paid out $4,723.20 ($35,973.00 - $31,249.80) less by using the IO Mortgage but by not paying off any principal we actually lost $2,222.43 ($6,945.63 - $4,723.63) in net worth during that time.

Let’s go one step further. IO Mortgages don’t stay IO forever. There is a point when the mortgage begins to amortize, that is, the borrower will be required to begin to pay down the principal owed. This typically occurs at 10 years. When we go out 10 years we find that we’ve paid $62,499.60 on the IO Mortgage and $71,946.00 on the standard 30-year fixed. We’ve paid $9,446.40 less by using the IO Mortgage but still owe $100,000. With the 30-year fixed our principal balance is down to $83,685.79. Our net worth difference is $6,867.81 ($16,314.21 - $9,446.40). Notice how much more principal we paid off from year 5 to year 10 $9,368.58 ($93,054.37 - $83,685.79) as compared to the beginning of the mortgage to year 5 $6,945.63 ($100,000 - $93,054.37).

At this point the IO Mortgage will require that the monthly payment reflect a principal payment as well as an interest payment. The new payment works out to be $730.93 ($100,000 @ 6.25% for 20 years). An increase of $210.10 over what the payment had been. From this point forward you payment now is $131.38 ($730.93 - $599.55) higher then what would have been paid on the standard 30-year fixed.

Today there are financing products designed to meet virtually any combination of conditions an applicant has to work with. They also carry various degrees of risk. In choosing the right mortgage you need to balance the potential saving of one product over another against your own tolerance for risk.

In considering an IO Mortgage you need to ask yourself, why am I considering an IO Mortgage? Is it because I want to buy a larger house than I can comfortably afford at this time? If this is the case, am I prepared for the “payment shock” when the mortgage stops being IO? Do I plan on selling the home before I get to year 10? In this case you need to look and see what might go wrong with your plans. If you plan on selling in 5 to 7 years then it is reasonable to assume the home will be sold by year 10. If you are planning to sell in 8 to 10 years, then maybe you should reconsider using this product.

Is an IO Mortgage right for you? Maybe. The only way of knowing is to talk to a mortgage professional to develop a detailed understanding of this product before making a decision. Lenders create mortgage products to fill perceived needs in the marketplace and then sell the product. Marketing the product as “a one size fits all” to the public. A true mortgage professional works in reverse. He evaluates your needs and recommends the product that fits you and explains why in terms that you can understand.