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For some buyers who are in the market to purchase a home, interest-only (I/O) mortgages (a mortgage loan where monthly payments apply only to the interest of the amount borrowed for an initial term at a fixed rate) may be an option. But buyers should be informed about the pros and cons of this approach. Advisor, Kevin Gahagan, answers some common questions on interest-only mortgages.

What are the advantages of an I/O mortgage?

The advantage of an interest only (I/O) mortgage is its much lower payment (when compared to an amortizing loan). A key consideration is the length of time you expect to own or hold the property. The shorter your holding period, the more compelling it is to have a lower payment – and the less risk there is that the rate will increase during your holding period. So, an interest only loan is most appropriate for someone who does not expect to hold a property beyond the interest only term of the loan (typically 5-10 years). Once such a loan extends beyond its interest-only term, the loan typically becomes a more conventional adjustable rate mortgage (ARM) and is fully amortizing. This means the payment will definitely increase significantly and the loan rate can rise as well.

When have you recommended an I/O mortgage approach?

I’ve recommended the I/O product in a divorce situation where one spouse is buying out the other’s interest in the home, needs affordable payments and does not anticipate holding the home long term. I’ve also recommended the I/O product where the homeowner anticipates moving in the next few years and is simply looking to reduce the cost to hold the property in the interim.

How were these loans typically structured and what were the terms?

In all cases, these were fixed rate loans through the interest-only period. We employed loans with a 7 or 10 year interest-only period. The loan terms dictated that once the interest only period ended, if the borrower still held the mortgage, the loan would convert to an amortizing ARM loan and be subject to rate adjustments subject to then prevailing rates. Assuming interest rates rose during the holding period, the loan would be subject to a gradual rise in the loan rate with the amount of adjustment and frequency dictated by the terms of the loan agreement.

As noted, the key advantage of an interest only loan is its much lower payment. To illustrate, the following are current rates through Quicken Loans / Schwab Bank (without factoring any Schwab account discounts that might be available)(1): The following payments are based on a $500,000 mortgage amount at stated rates (as of July 2, 2020):

7 /1 ARM (I/O period) 3.00% $1,250
10/1 ARM (I/O period) 3.25% $1,354
15-year conventional 3.50% $3,574
30-year conventional 4.00% $2,387

What are the disadvantages of an I/O mortgage?

The primary disadvantage arises if one holds the mortgage beyond its interest only period. As noted, at that point the loan adjusts to an amortizing loan and as you can see from the table above, the payment will rise significantly (even if the loan rate remained the same).  A secondary disadvantage is that none of the loan principal is being paid down over the term of the loan. This is primarily a disadvantage when compared to an amortizing loan with a shorter term (a 15-year mortgage versus a 30-year). In this example, a 15-year conventional mortgage can produce a great deal of debt reduction over a 7-10 year term. However, this comes with a payment that is three times greater. With a 30-year mortgage structure, the debt reduction would be significantly less over this same period (since interest repayment is front-loaded on conventional mortgages).

What advice would you give potential buyers when considering an I/O loan as it relates to their finances?

Be very clear about your objective in considering an I/O loan product and recognize the risk involved. These are most appropriate for those whose holding period is expected to be less than the term of the loan. It is almost always best to err on the side of seeking a longer I/O period even though doing so comes with a somewhat higher loan payment.

Read the article: Kevin speaks to CNBC about interest-only mortgages.