Interest Only Loan Payment Calculator
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Complete Guide to Interest-Only Loans
There is a reason why conventional loans have been named as such. Most consumers presume that 30-year and 15-year mortgages are their only real options, though some consumers know of adjustable rate mortgages (ARMs). These start with a lower interest rate before ballooning higher after a designated period, and they are popular due to the fact that the borrower has to pay less during the earlier portion of the mortgage.
They are not, however, the lowest potential monthly mortgage payments under the ARM umbrella. Interest-only loans are one of the least appreciated options for consumers seeking to pay less at the start of their mortgage. Here are eight important facts about interest-only loans.
Defining Interest-Only Mortgages
An interest-only mortgage is a special type of adjustable-rate mortgage. Unlike the standard version, it does not require a portion of your monthly payment to be directed toward the principal. Effectively, all that the borrower is required to pay each month is the minimum amount of money needed to stay current with the interest charges accrued in the loan. This concept sounds tricky, but it's not. Read on to understand the underlying mechanics.
Conventional Mortgages Include Hefty Interest Costs
The first important aspect of this borrowing process requires understanding of how a mortgage works. For a conventional 30-year loan, consumers agree to borrow a set amount of money. In exchange, they agree to make monthly payments for a set period of time. For a 30-year mortgage, the number of payments is 360.
What you may not realize is how little of your initial payments go directly toward paying off your loan. Here is an example to help you visualize the amount of money you pay toward loan interest rather than principal. The average amount of a mortgage varies on an annual basis, so the calculations will be performed under the presumption of a $250,000 loan.
If you borrow $250,000 in exchange for a 30-year mortgage at an annual percentage rate of 4.5 percent, you will eventually pay a total of $456,016.78. Out of those payments, $206,016.78 will be paid in interest charges. What you borrow today at 4.5 percent will be paid back with roughly 82 percent in additional costs.
Regular ARM Mortgages Are Better but Not Great
Even if you get an ARM loan, your payment would still work as follows. Each monthly charge includes a combination of principal and interest. Effectively, you pay back some of the money you owe, which is the principal. You also pay back some of the agreed upon interest charges, which are the cost of doing business for receiving the loan.
Since you receive a lower interest rate for an ARM loan than for a conventional 30-year loan, however, your payment is still lower. In the example above, the monthly payment would be $1,266.71 for 360 payments, allowing for some variation for tax adjustments. If your ARM rate is 3 percent for the first five years, you pay $1,054.01, a savings of $212.70 each month. That sounds great, but you can do better.
Interest-Only ARM Mortgages Require the Smallest Monthly Payments
Interest-only loans behave differently. There is no expectation from the lender that you will direct a portion of your payment toward the principal. You obviously can do so and frankly should if it at all possible, but there is no cost of doing business for declining to do so.
All that is required during the pre-adjustment phase of your loan is that you make the associated payments to remain current with your interest. Using the same parameters as above for monthly payments, the consumer would only be charged $668.89 monthly for the first five years of their loan.
Note that there would be absolutely no payment toward the principal in such a scenario, but you can still see the obvious advantage. The same loan costs $597.82 less each month than a conventional loan. It even costs $385.12 less than a standard adjustable rate mortgage.
Interest-Only Loans Have Cheaper Interest Rates
Maybe you can easily afford the monthly payment for a conventional loan. Even if this is the case, an interest-only loan is still worthy of consideration. The key is that interest rates for such mortgages are always lower than for standard loans.
Think about the obvious nature of this matter. Would you willingly use a credit card with a higher interest rate, knowing that you have one with a lower rate in your wallet? Then why are you willing to pay a higher interest rate for your home, knowing now just how much you will pay in total interest charges over the course of the loan? If you can afford the payments and have the good credit required to refinance down the line before the rate adjusts higher, you should strongly consider an interest-only loan.
Interest-Only Loans Are Great When Money Is Tight
Now that you understand the potential difference in monthly charges for an interest-only loan, here is the main reason why you should consider one. Anyone who has ever owned a home understands that the tightest year from a financial perspective is the first one. There are innumerable expenses involved in moving into a new home, which is why people often refer to themselves as mortgage-poor.
An interest-only loan liberates you from such concerns. During that pre-adjustment period, you have much lower monthly payments. You have that additional spending power each month to cover the costs of moving and furnishing your new house. After you have your new residence decorated to your satisfaction, you can pay more from that point forward. All of that additional money goes directly toward the principal, too.
Interest-Only Loans Empower You to Buy a Better Home
Do you know what a jumbo loan is? There is a government organization known as the Office of Federal Housing Enterprise Oversight that has defined the upper limits of conventional mortgages. If the cost of your choice of residence exceeds that number, you are forced to pay what is usually a higher interest rate. In the process, your dream home is potentially priced out of your range.
With an interest-only loan, that scary 30-year mortgage rate and its accompanying stiff monthly payment are not a concern in the short term. You can leverage the power of cheaper initial rates to afford the expensive home with an acceptable monthly payment.
Interest-Only Loans Have Some Innate Dangers
What happens if you fail to refinance before the APR rate on your interest-only loan adjusts? You suddenly suffer twice in one fell swoop. After the adjustment period, you are now required to pay toward principal as well as interest. This automatically increases the rate of your payment.
In addition, your interest rate has gone up as well. As was demonstrated in the example above, a higher interest rate dramatically increases the amount of your monthly payment. From just raising interest 1.5 percent, the payment costs over $200 more each month. You should see the problem here. Your required monthly payment could easily triple after the adjustment occurs. Be wary of this. If you do take one of these loans, make sure to refinance prior to scheduled adjustment.
Finally, just because interest-only loans enable you to buy a more expensive home does not mean that you can afford it. Be aware of the cost to own your home not just now but in the impending years after the interest rate adjusts. If you have any real concerns in this regard, you are probably looking at more house than you can afford.
Interest-only loans strengthen the options of potential home buyers. Rather than buy a conventional mortgage at a set rate, the clever consumer can either buy more house for the same monthly payment or pay what they want during the early phase of the loan.