How Does An Interest-Only Mortgage Loan Work?

I am often asked "How does an interest-only mortgage loan work?" The mechanics of how it works is pretty simple!

For example, let's figure out the monthly payment for a $400,000 mortgage with a 10% interest rate.

First, multiply $400,000 by .1 (10%). The answer is $40,000. This amount is the annual interest.

Next, divide $40,000 by 12 months. The answer is the monthly payment of $3333.33 per month. 

The loan balance with an interest-only mortgage never increases, but it can decrease if you decide to pay down some of the principal balance.

For example, suppose you win $100,000 in the lottery. You decide to pay down the $400,000 mortgage to $300,000. You would make a payment of $103,333.33 (interest owed plus principal you elected to pay).

By paying the principal down, there is an additional benefit besides the decreased loan balance - the monthly payment decreases!

The payment is now calculated by multiplying $300,000 by .1 (10% mortgage rate). The annual interest is now $30,000. Dividing the annual interest of $30,000 by 12 months calculates a payment of $2500 per month. 

Generally, an interest-only loan has the interest-only feature for a portion of the loan term and an amortized portion for the remaining of the loan term.

For example, if the term of the loan is thirty years, the interest-only portion of the loan may be for the first ten years, and the amortized portion for the remaining twenty years.

Let's look at the mortgage that has been paid down from $400,000 to $300,000 with the lottery winnings. 

At the end of the tenth year the lender will calculate the payment based on a twenty year amortization schedule.

A $300,000 balance at 10% for a twenty year amortized term requires a monthly payment of $2895.06 per month.

As a borrower with an interest-only mortgage, it is extremely important to know when the amortization portion of the loan starts. As you can see from the above example, the payment can rise substantially when amortization of the loan starts!

Now that you know how an interest-only loan works, you can ask the question "Would an interest-only loan make sense for me?"

For more information on any mortgage related question, I can be reached at (650) 222-0386, or you can e-mail me at pcaulfield@absolutemortgage.com.