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Interest Only Rates - Interest Only Rate Mortgages

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Traditional, fixed-rate mortgages have monthly payments that consist of both principal and interest. An interest only mortgage is one where the scheduled monthly payment includes only the interest portion of the payment. This option to pay only the interest lasts for a certain period of time, normally 5 to 10 years. Borrowers do have the option with an interest-only loan to pay more than just the interest portion if they want. Any additional amount paid would then be applied to the principal on the loan.

As an example of how an interest-only mortgage would work, if you have a 30-year, fixed-rate mortgage at 6%, the standard monthly payment (fully amortized with principal and interest) would be $599 per month. If you had an interest-only option on the same loan, the scheduled monthly payment would only be $500 per month. The $99 difference is the portion that goes toward paying down the principal in a more traditional loan. The borrower would then have the extra $99 per month available for other purposes.

An interest-only loan is not suitable for all borrowers, but may be an option worth considering in certain situations such as these:
• Those with fluctuating or irregular income: If you have commission-based pay or receive regular bonuses, for example, this option may work for you. The interest-only option would allow you to make smaller payments when money is tight, and then make larger payments to pay down the principal on your loan when your income is higher. You need to consider, though, if you would be disciplined enough to actually apply your extra income to your mortgage payment.
• Buy more house: Many home buyers start out with a smaller, less-expensive home and then gradually work they way up to a nicer home. Interest-only loans could allow you to skip past the starter home and go directly to a nicer home. The risk here would be that real estate values could drop and/or your income may fail to go up as you had hoped.
• Invest the extra money each month: Paying interest only, the rate your money grows, if you were to invest it, could be greater than the growth rate if you were to apply it to the principal on your mortgage. The big question to ask yourself in this scenario is if you would actually invest the difference. If so, you could come out ahead with the right investment choices. If not, you’re probably better off with a traditional loan that builds equity in your home.
• Quick gain: If your home is in an area where real estate values are rising quickly, and you don’t expect to hang onto your home very long, an interest-only rate mortgage may benefit you. It could allow you to buy more house and leverage your investment into a larger capital gain when you sell. The risk here is if real estate values fail to rise as you would hope.
• Pay down other debts: If you have a second mortgage, credit card, or other debts with a higher interest rate, an interest-only rate mortgage could free up cash to pay down those higher-rate debts.

What are the risks of an interest-only rate mortgage?
• Anyone who does not meet any of the criteria or situations listed above should probably stay away from interest-only loans.
• Be aware that lenders view interest-only loans as riskier than a fixed-rate mortgage, for example. Because an interest-only loan will have a higher outstanding balance than a fixed-rate where the principal is being paid down, the lender has more exposure. More exposure equals more risk, and more risk equals a higher interest rate.
• Most interest-only rate mortgages are also attached to adjustable rate mortgages (ARMs). ARMs, due to the possibility of increasing monthly payments, are also considered more risky than fixed-rate mortgages. Many Americans were caught in the trap of increasing ARM payments and decreasing real estate values over the last few years.

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