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Thursday, August 24, 2006

Basic Terminology: Interest Only Mortgage

A very common tactic used by homebuyers who want to maximize their borrowing power is the Interest Only (IO) mortgage. As the name suggests the payments on these loans only covers the interest accumulated during the month. The payment does not include any money towards lowering the principal balance of the loan.

The IO term is usually from five to ten years, and then the loan generally converts into a standard principal and interest loan. At the conversion the payments are calculated based on the remaining term. This means that if you get a 30 year IO mortgage, you will have a low payment for the first 5-10 years since you are only paying the interest, but then you have a higher payment than you would for a normal 30 year term since your remaining payments must payoff the full balance in 20-25 years rather than 30. This can come as a big shock since payments can sometimes double or triple.

The smaller payment during the IO portion will improve the borrower's debt to income ratio. In a hot real estate market such as California sometimes this is the only way that people with average incomes can afford average houses. The obvious down side is that if you sell the property during the IO period you haven't gained any equity in the house except for appreciation. If the housing market takes a turn and the house depreciates instead then the borrower ends up owing more than they can sell the house for.

The official suggestion of the Mortgage Insider is to avoid Interest Only mortgages, and instead try to find a 40 or 50 year fixed rate mortgage, or a long term balloon. Lenders are increasingly promoting these options as a way to hedge their risk. Borrowers are more likely to default on a loan where they have little equity in the property, so any loan that builds equity mitigates that risk.

Interest Only loans also have a higher rate than their non-Interest Only counterparts. 0.15% or higher adjustments to the rate are common. So, save yourself the extra interest and earn some equity at the same time with a long term fixed rate loan.

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