How an Interest-Only Mortgage Works

March 29, 2007

Let’s say you want to buy a house and will need to finance it with a $200,000 mortgage. You meet with a mortgage broker and they show you two loans: a 30-year fixed rate mortgage at 6.30% and a 30-year fixed rate mortgage with an interest-only period of 15 years (also at 6.30%). How do you compare these two mortgages?

30-Year Fixed-Rate Mortgage

Using this calculator, you can see that the payment on a $200,000, 30-year fixed rate mortgage at 6.30% would be $1,238 (or $1,237.95 to be exact). Beginning with the very first payment, a very small portion of the payment will go towards the principal of the loan and a very BIG portion of the payment will go to pay interest as the graphic below shows:

Notice that the beginning balance for the second month is smaller than the beginning balance from the previous month. That’s because a portion of your payment is going towards the principal. As you continue to pay on your mortgage, the percentage of each payment that goes towards interest will decrease while the amount going towards the principal will increase. Towards the end of the mortgage term, most of the payment will go towards principal and very little will go towards interest. For more on how the math of a mortgage works, see this post I wrote last year.

Pretty simple stuff. Now let’s look at an interest-only mortgage.

30-Year Fixed Rate Mortgage With a 15-Year Interest-Only Period

An interest-only loan is essentially two loans rolled into one. For example: a 30-year fixed rate mortgage with a 15-year interest-only period works out to two 15-year loans. As we calculated in the first example, the interest amount on the first payment is $1,050. With an interest-only mortgage, your initial payment would be $1,050, which is $187.95 smaller than the traditional payment:

Notice that because all you are paying is interest, your loan amount stays the same. In other words, you pay each month but you don’t make any progress on actually paying off the loan. This would continue for 180 payments (15 years). At the end of 15 years, you will still owe $200,000 on your mortgage. In order to pay off that mortgage in the next 15 years, you will have to pay substantially more each month. How much more? Well, you can calculate it yourself using this calculator. For the input, use 15 years, 6.30% interest rate, $200,000 for amount borrowed. You should get $1,720 ($1,720.30 to be precise) or $670 MORE per month! You’ll then have to pay $1,720 per month for the next 15 years (180 months).

What About Equity?

Equity in a house comes from two sources:

1. The amount of each payment that goes towards principal. At the end of 15 years, the traditional mortgage would have built up an equity position of $56,078. You would have built no equity position from payments with the IO mortgage.

2. The appreciation in the value of the home. In the example, if the home appreciates at 3% per year, at the end of 15 years, it will be worth $311,594.

With the traditional 30-year fixed mortgage, at the end of 15 years, you will have an equity position of $167,672 [$56,078 equity built up in the mortgage + $111,594 appreciation in the value of the home). With the IO mortgage, your equity-position will just be the increase in the value of the home ($111,594). NOTE: There’s NO GUARANTEE that the house will appreciate in value. Some areas of the U.S. have experienced price declines, which put some people in negative equity positions (not a good thing!).

At the End of 30 Years

As you can see from the graphic below, the interest-only mortgage carries with it significantly more in interest charges. However, this doesn’t tell the whole story as it leaves out the potential growth in the payment difference and the tax deductibility of the interest (more on this in a future post).

At first glance, the IO mortgage does not appear to be that great of a deal. You’re only “saving” $187 per month and that only lasts for a while. If you can’t afford the $187 difference, should you be buying the house? Good question.

More on this later…

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