At some point during the home buying process, someone—your loan officer, your realtor, your uncle—will suggest you look into “going interest only.” It’s an option worth considering and that’s exactly what we will do in this month’s installment of “Owning a Home.”

How does a standard mortgage work?

As we know, a standard monthly mortgage payment consists of principal and interest. The interest is frontloaded, meaning that initially your payment is almost all interest. As the loan amortizes, the percentage of principal gradually increases through the life of the loan.

For example, a 30-year fixed rate mortgage of $100,000 at 6 percent has a monthly payment of $599.56. This is the fully amortized payment—the payment which, if maintained over the full term of the loan, will just pay it off.

In the first month, that payment divides into $500 of interest and $99.56 of principal. In month two, the payment remains at $599.56 but the breakdown is $499.50 and $100.06. Each month, the interest portion declines and the principal portion rises. After five years, the balance on the loan is $93,054. You will have paid $35,973.60; only $6,946 of that will have gone to equity in your home, and $29,027.60 will have gone to pay interest. That is how mortgages amortize.

How does an interest only mortgage work?

As you might suspect, a mortgage is interest only (IO) if the scheduled monthly mortgage payment—the payment the borrower is required to make—consists entirely of interest on the loan. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Borrowers have the right to pay more than interest if they want.

Back to our first example. Now let’s attach an interest-only option to the above mortgage, available, say, for the first five years. That means that the borrower is required to pay only $500 a month during the first five years. There is no payment to principal.

Why go interest only?

Financial flexibility. This is the primary reason a first-time homebuyer might consider going interest only. A concern of many first-time homebuyers is keeping their new home payment as close as possible to their current home payment, i.e. rent. Going interest only may enable you to accomplish that goal.

At the same time, we actors and artists have incomes that often vary from month to month, so having some payment flexibility may be of value. If you land a couple of extra bookings, you can pay down some principal or use that extra cash flow for whatever else you need. If you have a little less in your savings account than expected at the end of the month, that lower mortgage payment will be easier to handle.

Qualify for a larger mortgage. If you are trying to maximize the amount of house you can buy and are limited by your income, the IO option lowers the monthly housing payment, which allows you to qualify for a larger loan amount.

Allocate Cash Flow to Second Mortgage. Let’s say you are financing your home purchase with an 80 percent fixed-rate mortgage (FRM) at 5.75 percent, and a 20 percent second mortgage at 8.75 percent. If the FRM is IO, you can use all your available cash flow to pay down the balance on the second mortgage. This makes sense because of the higher rate on the second mortgage.

Any drawbacks to going interest only?

First, it is important to note that not all programs have interest only options, so if you are interested in this option it is important to let your loan officer know as early in the process as possible.

Not building equity. The bottom line is that with an interest only loan you are not required to pay down any principal. With a five year interest only ARM of $100,000, for example, your balance after five years would still be $100,000. If you are not paying down principal, then you are not increasing the amount of equity you have in the home.

The counterpoint to this is that with a standard mortgage over those first five years, your payment is almost all interest anyway. With a standard mortgage, as detailed above, you will have paid down a little less than $7,000 of a $100,000 loan after five years. If that $7,000 is better served remaining in your savings account to handle your day-to-day expenses, then an interest only loan might be a worthwhile option for you.

Might increase your rate slightly. Lenders might charge a higher rate for a loan with an interest-only option, because the risk of default is a little higher on loans that amortize more slowly. Generally, rates are no more than a quarter point higher for mortgages that are interest only.

How much does that quarter point matter? In the 30-year fixed rate mortgage of $100,000 at 6 percent we mentioned earlier, you would pay $500 per month in interest and $99.56 in principal. If that mortgage had an interest only option and a rate of 6.25 percent, you would be paying $520.83 in interest and $0.00 in principal. You are able to claim that extra interest on your taxes.

As always, feel free to call or e-mail me anytime with any home buying questions you may have. Also, please send me any comments or suggestions about this article and let me know if there are topics you would like to see discussed. Talk to you next month!

Mike McNamara has been an actor in Chicago for the past seven years in theatre, commercials, television and film. Mike is also a mortgage consultant and loan originator with West America Mortgage Company. He can be reached anytime at 773/398-0021 or McNamara310@aol.com.

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