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Often times, you may hear of interest-only mortgages accompanied by screaming headlines stating how risky of a loan option they can be. In actuality, interest-only mortgages are simply loans that have been secured by real estate that contains a choice to make an interest payment.

## HOW DOES AN INTEREST-ONLY MORTGAGE OPERATE?

Lots of interest-only mortgages in existence today have an option for making interest-only payments, which are payments thatdon’t contain principal.

For example, a $200,000 loan with an interest rate of 6.5% amortized over 30 years would require payments of $1,254 per month, which contains both principal and interest.

The interest only payment would be $1,083, making the difference between a principal and interest payment and an interest-only payment ring in with a $171 per month savings.

## THE MOST COMMON INTEREST-ONLY MORTGAGES

Borrowers can’t continue to make interest-only payments forever on the most common types of interest-only mortgages. Usually, the time period for making interest-only payments is capped to the first 5 or 10 years of the loan.

After the interest-only payment period has elapsed, the loan is then amortized for the remaining term of the loan. This does not increase the loan balance, but the payments move up to an amortized amount.

Let’s look at two popular interest-only scenarios:

**The 30-year loan:**

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Making interest-only payments is allowed for the first 5 years, or 60 months. Therefore, a $200,000 loan at 6.5% interest means the borrower can pay $1,083 each month any time during the first five years. When years 6 through 30 arrive, the monthly payment will be increased to $1,264.

**The 40-year loan:**

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For a 40-year loan, the interest-only payment period is notably longer, for the first 120 months. A $200,000 loan at 6.5% interest rate means the borrower could choose for the first ten years to pay interest-only payments at any time, but for years 11 through 40, the payment would be $1,264.

## HOW TO FIGURE OUT AN INTEREST-ONLY PAYMENT

To determine mortgage interest payments, let’s use an unpaid loan balance of $200,000 – and then multiply it by an interest rate, such as 6.5%.

Since 6.5% times $200,000 equals $13,000 inannual interest, we can divide $13,000 by 12 months in order to get a monthly interest payment of $1,083.

## WHY CHOOSE AN INTEREST-ONLY MORTGAGE ?

People buying homes for the first time might be attracted to interest-only mortgages, because the lower monthly payments are more akin to the rental payments they have been accustomed to making. If a person is used to paying $700 per month in rent for a one-bedroom apartment, they may find it easier to transition to a $1,000 per month interest-only mortgage payment instead of jumping into a $1,250 monthly principal and interest payment right away.

Just because a person has an interest-only mortgage doesn’t mean they must make an interest-only payment. It merely gives the borrower the option to pay lower payments during the beginning years of the loan.

This could come in handy if the homeowner getsan unexpected bill that takes a bite out of the household budget, for example, if they need to spend $500 to repair the water heater.

If they choose to pay the reduced interest-only payment that month, that choice might free up the cash they need to direct to other expenses and keep the budget in balance. People who work in careers with unpredictable monthly incomes, like salespersons who earn commissions instead of flat monthly salaries, might also benefit from an interest-only mortgage option.

In order to balance out the amount owed on the total loan, borrowers many times pay interest-only payments when they are low on cash, and then pay extra amounts toward their principal balance when they receive bonuses or commissions.

## WHAT DOES AN INTEREST-ONLY MORTGAGE COST ?

The downside is that an interest-only mortgage might cost a bit more than a conventional loan. If a 30-year fixed-rate mortgage is available at 6% interest, the interest-only mortgage version could cost an added 1/2 percent or come with an 6.5% interest rate.

On top of that, some lenders might tack on an additional percentage of a point to make the loan – but since fees vary by lender, it pays to shop around.

## RISKS AND MYTHS OF INTEREST-ONLY MORTGAGE LOANS

Interest-only mortgage loan balanceswon’tever increase, unlike other, riskier loans. One risk of this type of mortgage, however, is when buyers are forced to sell their property if it hasn’t appreciated in value.

Let’s say that a homeowner has been paying only the interest monthly and after five years the borrower will still owes the original loan balance because the principal has not been reduced at all, only the interest has decreased.

That’s why larger down payments at the onset of the loan when the property is first purchased helps to mitigate and reduce this risk associated with an interest-only mortgage.

Additionally, if the values of properties decrease, the equity gained from the property at the time of purchase could disappear. This is a risk that most homeowners assume anyway in a downturned market.

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