Interest-Only Loans Carry Additional Risk.
Like never paying down your mortgage. An interest-only loan lets you pay simple interest on your mortgage, while also letting you pay down the principal at your leisure. The trap with interest-only mortgages is that if you don't get into the habit of paying additional principal every month, your original loan stays the same.
To calculate the payment on an interest-only loan, just take your loan amount and multiply it by the interest rate, then divide by 12.
If your rate is 5.00 percent and your loan is $400,000, then your interest-only payment is 5.00% X $400,000 = $20,000 divided by 12 = $1,667 Per month. To compare that with a fully indexed 30-year fixed-rate loan at 5.00 percent, the monthly payment on the fully indexed loan is $2,144.
That's quite a difference, and it also shows you how much goes toward your principal each month. You need to have the discipline to make principal payments, or else the interest-only loan can cause you problems.
Low-Money-Down Loans and Interest-Only Don't Mix.
If you don't pay your balance down and you use a low-money-down loan, these loan programs can hurt.
Remember that it costs money to sell a home. Commissions, title insurance, legal fees—they all add up. If you put little or nothing down, you automatically have very little equity. If you don't pay down your principal at all, you'll have to come to the closing table with money when you sell instead of taking money away.
Let's say you buy a home for $300,000 and put 5 percent down, and in three years you have to sell. Your loan balance at the beginning was $285,000. You also take out an interest-only loan and don't pay anything toward the principal during that same three-year period. Then you get transferred to another location and have to sell your home.
Closing costs on your sale might be $25,000. And unless your property has appreciated enough to cover those costs, your situation would look like this:
Sales price $ 300,000
Loan payoff ($285,000)
Closing costs ($ 25,000)
Balance ($ 10,000)
To pull off this deal, you have to bring a check for $10,000 to closing. If you had put more money down to buy the property, say 10 to 20 percent, you would just skate by. Or if you put little or nothing down and had a fully amortized loan instead of paying interest only, you'd narrow your losses.
On a 6.00 percent 15-year fixed-rate loan with 5 percent down, loan amount $285,000, after three years, your loan balance would be about $246,000. With natural amortization, your equity position has grown, and now not only do you have enough to cover your payoff and your closing costs, but you actually take home $29,000.
When you mix a low-money-down loan with interest only, you're setting yourself up for a potential disaster.