Interest Only loans are a new phenomenon in mortgage banking. Rather than amortizing your loan over the loan period (15 or 30 years), an interest only loan will have a period of time where you are only paying interest on the original loan balance (loan is fully amortized over the remaining period). Usually, you can make additional payments to reduce the principal balance any time. This will have the effect of reducing your interest only payment the following month.

For example, assume you are purchasing a property for $250,000, of which you will finance $200,000. You have been quoted a rate of 6% for a 5/1 ARM fully amortized over a 30 years and the same rate of 6% for a 5/1 ARM that is “interest only” for the first 10 years. The monthly payment for the fully amortized loan is $1,199, and the monthly payment for the interest only loan is $1,000, or a difference of $199 per month.

The question is whether or not this is a wise thing to do?

In the case of the fully amortized loan you are building equity each month by reducing the principal loan balance. In the case of the “interest only” loan your principal loan balance remains the same. The answer to the wisdom of one vs. the other is dependent on a number of factors, such as – your stage of life, your cash flow situation, the extent to which your income is variable, your self discipline in making extra payments to reduce the principal loan balance as funds are available, the extent to which property values are appreciating or depreciating in the area where this house is located and whether this is your principal residence or if it’s an investment property. Bottom line...better call me on this one.

One of the advantages of an interest only loan is that you have the option of making the minimum interest-only payments or making a principal reducing payment. A potential disadvantage of an interest only loan is that you are not “forced” to reduce your principal loan balance and build equity in your property. If you chose to invest the difference between the interest only payment and the fully amortized payment in an investment that goes bad – you have lost the equity that you would have built up because you didn’t make the principal loan reduction payments.

The bottom line is that loans that are interest –only can give you flexibility and payment options that are not possible with the more traditional fully amortized loans. But remember, that with flexibility comes responsibility, and you must evaluate this option in light of all your other investments to make sure that you aren’t becoming more speculative than is wise or prudent.

Douglas Boncosky is a Licensed Mortgage Planner with Smart Mortgage Access in Schaumburg, IL. Doug has written a number of articles about mortgage related financing including his popular book titled "First Time Home Buyers Guide to a Stress Free Home Buying Process" Doug also writes a series of business improvement articles to help his marketing partners grow their business. Doug can be reached at http://www.dougboncosky.com

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