Today I want discuss Interest Only Loans. While these loans used to be very common in the pre-2008 era, they have fallen out of popularity/availability since then, to the point that I think Realtors could use a refresher on the dynamics, pros, and cons of this type of loan. (I personally do not think interest only loans played a large role in the overall crisis that happened in 2008. I think stated income loans, subprime loans, and $0 down payment loans were much bigger culprits. I am a fan of interest only loans to be used a financial tool for the right borrowers.)
On a traditional loan, the monthly payment includes principal and interest. An “Interest Only” loan means that the borrower is only required to pay, for a specific period of time, the interest on the loan. Since no payment to principal is made, the loan balance does not go down.
Golden 1 Credit Union offers 5 Year and 7 Year ARMs with an interest only feature. Here is an explanation of how this loan works, using a 7 Year Interest Only ARM as an example:
Just like a traditional 7 Year ARM, the interest rate is fixed for 7 years and then begins to adjust every 6 months for the remaining 23 years of the loan.
For the first 10 years, the borrower is only required to make interest only payments. They can choose to pay extra to principal at any time without penalty, but the minimum payment is interest only for 10 years.
For Years 1 through 7, the payment will be based on the interest on the loan balance at the locked interest rate. For example, a $1.5M loan at 5.75% would have a payment equal to ($1,500,000 * .0575) / 12 = $7187.50. For Years 8-10, the rate will be adjusting, so even though the borrower still does not have to pay principal during that time, we don’t know exactly what the payment will be since the rate is unknown.
After 10 years, the loan becomes a Principal and Interest loan based on a 20 year amortization and based on the adjustable rates at that time.
There are two main benefits of an interest only loan:
Most obviously, the initial payment is lower than a principal and interest loan.
Interest Only loans have an “automatic recast feature” during the interest only period. This means that if a borrower pays down their principal, the required payment will automatically decrease the next month since it is based on the interest on the outstanding balance on the loan. For example, if someone pays down $100K on the loan and the rate is 5.75%, then the monthly payment will automatically reduce by $479 per month without having to go through a formal recast process.
There are four main downsides of an interest only loan:
The payment can increase significantly after the rate starts adjusting and the loan becomes a principal and interest loan.
The interest rates are typically ~0.25% higher than principal and interest loans.
These loans are more difficult to qualify for than traditional principal and interest loans. Because the loan balance can be the same after 10 years when the loan converts to a principal and interest loan, the payment lenders use to calculate the debt to income ratio is based on a 20 year amortization rather than a 30 year amortization. This means that a borrower has to have significantly more income to qualify for this type of loan. Many lenders also require a higher down payment (Golden 1 requires 25% down).
Because you aren’t paying principal down, you end up paying more in interest over the life of the loan.
Here are the types of people I think that can benefit the most from an interest only loan:
High income borrowers who will have some short term reduction in income in the future, and they want to be able to utilize the interest only feature during that time. The most common example would be a couple who plans to have children in a couple of years and plans on one parent not working for a few years. They may plan on making the principal and interest payment initially, but just want to have that lower payment option for a couple of years when they are on a single income.
Real estate investors purchasing an investment property like to have the option to make the interest only payment during months that they do not have a tenant. (Golden 1 only offers interest only loans for primary residences, but other lenders may offer this.)
Borrowers with investments that yield them significant returns on their money. In this case, the more money they have each month to invest, the better, so a lower mortgage payment is helpful.
Borrowers that will heavily utilize the automatic recast feature of interest only loans. These are often people with significant stock vesting each year, and they want to pay down their mortgage by a couple of hundred of thousand dollars per year to reduce their monthly payments.
If you have any buyers who would like to discuss interest only loans, I would love the opportunity to help them. They can email me or call me at 408.313.8970.
Have a wonderful weekend!
Jamie Myers | Home Loan Advisor
Golden 1 Credit Union
C (408) 313-8970
880 E. Campbell Ave, Suite 104
Campbell, CA 95008