|
 Dear
Dr. Don,
Can you explain to me what an interest-only loan is? I've been reading various books saying that it was cheaper than paying a 30-year loan. When I pay my monthly mortgage payment it is $566 in interest and $147 in principal. That doesn't sound like a big savings to me, will you explain?
Thanks.
-- G. B. Mortgage
 Dear
G. B.,
A self-amortizing loan has a payment large enough to both
cover the monthly interest expense on the loan and to repay the principal balance
over the life of the loan.
In the early years of a self-amortizing
loan, most of the monthly payment goes toward
the interest expense. Each month the interest
expense goes down by a little bit and the principal
payment goes up a little. You can use the amortization
schedule on Bankrate's mortgage
payment calculator to see precisely how this
works.
With
an interest-only loan, the monthly payment is equal to the monthly interest expense.
You're not paying down the loan balance at all. The typical interest-only
loan converts to a self-amortizing loan 10 years in to its 30-year final maturity.
At that point in time you'll have a much higher monthly payment because you only
have 20 years to pay off the principal balance.
Interest-only loans also tend to
be structured as 5/1 or 7/1 adjustable-rate mortgages,
or ARMs. That means that the interest rate is
fixed for five or seven years before it starts
adjusting annually to changes in market interest
rates. You'll take on a measure of interest-rate
risk in these loans if you plan on being in the
house longer than the initial fixed-rate period.
Interest-only loans were
once the domain of the wealthy. They didn't want to pay down the note because
they had better places to invest their money. The interest-only structure become
popular with less wealthy consumers who used this loan structure to qualify for
loans on homes they couldn't otherwise afford. A rising tide
lifts all boats. Interest-only loans didn't appear to have any drawbacks when
housing prices kept rising. Homeowners built equity with price appreciation instead
of with principal payments. In a softening real estate market, you can face risks
with these loans that you wouldn't face with a 30-year fixed rate mortgage.
| 
