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Possible Risks of Interest Only Loans

The risks of all financial products vary depending on your unique financial situation and interest only home loans are no different.  Some of the potential risks behind interest only financing are listed below.

Negative Amortization - Does this apply?


Possible Payment Shock


Who Are Interest-Only Loans For?


How will I know my future interest rate?


How can you measure your risk level?


Limited Income Consumers


Related Topics      Popular MYTH'S       Benefits of Interest Only Loans


Negative Amortization & Interest Only Loans

There is a common misperception that all interest only loans have a feature called negative amortization.  If you think this then you need to read the following because most interest-only loan programs that are available with short term fixed rates DO NOT have negative amortization.

Many loan officers are learning interest-only programs for the very first time and one of the most popular programs over the past few years has been what's known as the Option Arm or MTA loan.  These loans are advertised with rates as low as 1.00%.  First of all, these loans contain the possibility of negative amortization (which common libor loans almost never) and if you are financing above 90% of the value of your home it is almost impossible to secure a second mortgage or home equity loan.  If you do, your rate will be something which will make you think about reconsidering your first mortgage.

The good news is that almost all LIBOR loans do not have this feature.  If you hear a loan officer explaining a program with a rate that's too good to be true and he starts mentioning how you have four payment options then this loan (called an option arm or pay option loan) is not the common interest only loan you have heard your friends talk about.  The best way to understand all the interest only programs is by using our products tab on the top menu.

Possible Payment Shock ...

In order to understand the possibility of payment shock you must first understand what an interest-only loan is - see above.  Many of today's home loan programs offer interest-only payments for only a defined period of the note so something has to happen in order for your loan to be repaid within the original terms of the note.  For a basic summary let's assume you have a 30 year note with 10 years of interest only payments.  Your lender still requires the note to be paid off in 30 years.  What happens here is that after your interest only period has lapsed you will begin to pay "principal and interest" payments to the lender.  The possibility of payment shock is very real for those consumers who hold on to these loans past the interest only period.  The reason is simple.  Since you are required to pay off this loan in 30 years you now have only 20 years remaining (using the example above).  In order for a lender to amortize your loan and ensure repayment in the remaining time period your loan payments will now be calculated on a 20 year schedule using your current balance.  Remember, the payment shock is very real for those consumers who have paid nothing towards principal in the first ten years.  The more principal you pay down during your interest-only period the less shock your new payments will be but it doesn't mean payment shock will not exist since many factors go into determining your payments when the time comes including then current interest rates.

Are these long term loans - Who are they for?

Unless your risk level is high then interest-only loans are generally not long term loan programs.  However, with the said, interest only loans can provide a great option for many homebuyers such as:

  • High Net Worth Individuals:  Consumers who generally do not wish to tie up the equity in their home and would prefer to invest the extra money into markets of better return.

  • Young Professionals:  Consumers who are sure their income will grow but would like greater purchasing power today.  For example, young lawyers & doctors

  • Short Term Homeowners:  Consumers who know the time frame for home ownership is within a certain window of time and are more concerned with payments than equity.

  • Real Estate Investors:  Consumers purchasing investment property find interest only loans very valuable in areas where real estate appreciation is high.

This is not to say that an interest-only loan may not be right for you but every program has a certain profile of consumers who tend to show the majority of interest.  If you think an interest-only loan can benefit your life it would be a good idea to contact a mortgage lender & consult with your financial advisor to make the best decision for you and your family.

After the interest-only period how will I know my rate?

This is a very common question from consumers who are new to the interest-only mortgage product.  After the interest-only period your loan will be subject to future market rates however your margin will not change throughout the remaining term of the loan.  Your interest rate will adjust regularly according to the predefined terms contained within your interest-only mortgage note.  It's usually on an annual basis but varies from lender to lender.  It is important that you ask you loan officer before you apply.  Below is a hypothetical example of what could happen when a consumer comes out of the interest only period. Let's say your note called for your interest rate to be determined by adding the current libor rate + a margin of 2.25.  If the libor rate is 2.00% during month 61 you will have a new interest rate of 4.25% until the next adjustment period.  It's important to remember that these are now principal and interest payments so your payment may be higher even if your interest rate is lower.

How can you measure your risk level?

It is extremely important to note that your risk level is not always judged by how you feel.  Many factors go in to determining if an interest only loan is right for you.  It is imperative that you understand the following points before searching for a loan officer:

  • A Loan Officer Should Not Be Your Only Advisor - Many mortgage professionals are only trained in one area of the financial sector and can not advise you If an interest-only loan is the best financing program for you and your family.  He/she can answer your questions on interest only loan programs and help guide you towards making a better informed decision.

  • Loan Officers are not Financial Advisors  - They are sales people.  If you are seeking financial advice you need to seek the assistance of a trained professional such as a CPA, retirement planner or investment advisor.

It is a fact that if you are on a fixed income and are pretty sure that your income may not rise in the future then interest only loans will probably bear a much greater risk for you.  As with all matters that have to with your finances you should consult a financial advisor who is aware of your unique situation before entering into any agreement with a mortgage lender.  Never rely on the sole words of a loan officer.

My Income is limited - is an Interest-Only Loan for me?

if you are on a fixed income then interest only loans will bear a much greater risk for you.  It is highly recommended by most real estate professionals that consumers with limited income do not engage into home loan programs with interest only payments.  Once the interest only payments are over you may find yourself in financial trouble due to higher monthly payments.  Additionally, if your credit has changed you may be forced into a position where refinancing is not  a very attractive option.  Although we do not provide advice as a rule we can say that it's important - probably imperative - that consumers with limited income plan on the future, not the short term.  This is what interest only programs are - short term options for a select group of homeowners.

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