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Sunday, May 22, 2005

Understanding Interest-Only Mortgages

I have been hearing a lot of talk lately about interest-only (I/O) mortgages. These are mortgages that require the borrower to only pay interest (rather than interest and principal) the first few years of the mortgage, thereby reducing the payment amount. Is this a good idea?

I found a really good explanation of interest-only mortgages over on the HSH website in an article titled The Principal Facts of Interest-Only Mortgages. From what I can gather, I/Os are basically two mortgages rolled into one. I/Os can be paired with adjustable-rate mortages (ARMs) or fixed-rate mortgages. Basically, here's how they work:

Mortgage Amount: $120,000
Loan type: 30-Fixed at 6%
Standard Payment (principle + interest): $719.46
Interest-only period: 5 years (60 payments)
The interest portion on the first payment would be $600 - "saving" the borrower $119 per month. The payments would then decline with each subsequent payment. At the end of 5 years, you would pay a total of $34,832.87 in interest.

At the end of 5 years, you would still owe $120,000 on the house, which would then have to be financed. But, instead of 30 years to finance the mortgage, you would have 25 years. So, your new payment would be $773.16 per month, $53.70 more than the orginal payment and $173.16 more than the I/O payment.

Over the next 25 years, you would pay an additional $111,948.50 in interest for a total of $146,781.37 in interest over the entire period. Had you gone strictly with a standard 30-year fixed mortgage, you would have paid $139,006 in interest over the course of the loan or $7,775.37 less than the I/O mortgage.

Those are the facts as I see them. With my next post, I'll go into more detail about the pros and cons of I/O mortgages.

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