Many people have taken advantage of low interest rates to purchase their first home or to refinance a high-interest home loan in recent years. Traditionally, purchasing a home meant signing a 30-year, fixed-rate mortgage loan, where your monthly principal and interest payment remains the same for the life of the loan. There are a variety of loan products in today’s market. If you are buying a new home or refinancing your current home mortgage, you may have heard about interest-only or IO loans. This article can help you understand how these loans work and whether or not such a loan is right for you.

I am getting a mortgage loan for my home. The broker is telling me that I can have lower monthly loan payments for the first 10 years with an IO loan. What is an IO loan?

An interest-only or IO loan is a loan that gives the borrower the option of paying only the interest portion of the loan each month during the first three to 10 years of the loan. None of the monthly payment is credited towards the principal of the loan. With an IO loan, your monthly payments for the first three to 10 years of the loan are lower than what you would pay if you had a standard fixed-rate 30-year mortgage loan. This allows many people to purchase a house that they could not otherwise afford. It also means that, under certain circumstances, people may buy more home than they can afford and will have trouble keeping their home when the interest-only payment period ends.

IO loans are one of the fastest growing loan products on the market today. For many, buying the home of their dreams would be impossible without an IO loan. But for some buyers, the risks an IO home loan outweigh the advantages. While the initial lower monthly payments can be very attractive, it is important to remember that you are not gaining equity in your home during those years when you are only making interest payments. You still owe the full principal amount of your loan. However, if you have an IO loan, there is no penalty if you make payments towards the principal during the interest-only period of the loan. Such additional payments help you gain equity in your home more quickly.

The broker says that I can get a fixed-rate or adjustable-rate IO. What is the difference?

IO loans may have a fixed or adjustable interest rate or an initial fixed rate that converts to an adjustable-rate mortgage or ARM on a certain date. Fixed-rate IO loans maintain the same interest rate for the life of the loan. ARMs have periodic interest rate adjustments. The interest rate may rise, depending upon interest rates in the financial market. Some IO loans with ARM options have interest rate adjustments that begin within the first six months of the loan. The details of when the initial rate change occurs, how often rate adjustments will occur, and how high or low the interest can be are all included in the loan terms. It is important to get all the facts about when rates change, how often rates change, and how high interest rates can go before you sign a loan. Remember, you have the right to shop for the best possible loan terms.

At this time, home loan interest rates are still low. Experts in the home mortgage industry are not sure how long this will continue. If you have an IO loan that converts to an ARM, then you have to think about the future and whether you will be able to afford increases in the interest rate in addition to the payment increase once you start paying down the principal of the loan.

If you have a fixed-rate IO loan, the interest rate will remain the same for the life of the loan. The interest rate may or may not be a little higher if you choose a fixed-rate IO loan over an ARM IO loan, but the interest rate will never go up, no matter what happens to mortgage interest rates in the future. Some ARM IO loans may offer a low "teaser rate" for the first month or two of the loan. Be careful! That rate may go up and become higher than the fixed rate you were offered. Always ask how long the initial rate will be in effect.

If I take this loan, what happens after the first interest-only period ends?

Earlier, we said that while you are making interest-only payments, the principal amount of your loan remains the same. So, after the interest-only period ends, if you have only paid interest, you still owe the original loan amount. Starting in the next year of the loan, you will have to make payments on the interest and the principal, which means that your monthly loan payment will increase. You will need to have enough income to cover the increased payment.

Can you show me an example?

Here’s an example of what the difference would be between a $100,000 IO loan (with a 10-year interest-only period) at 6.25% fixed rate over 30 years and a fixed-rate 30-year loan at 6.25% without the IO payment option. With the IO loan, your monthly payment for the first 10 years is $520.83. With the fixed-rate 30-year loan, it is $615.72, a difference of $94.89. Starting in the 11th year, your IO loan monthly payment will increase to $730.93, because you must now pay down the principal as well as continue to pay interest. The fixed-rate 30-year loan monthly payment will still be $615.72 in the 11th year, but you will have already paid down $16,040 of the loan principal, which means you will have gained equity in your home.

Why is the IO loan payment higher than the fixed-rate mortgage loan payment after 10 years?

There is a $115.21 difference in the loan payments because you have to pay off the principal of the loan in 20 years rather than 30 years. Remember also that the example we have used is for a fixed-rate IO loan. If you choose an IO loan with an adjustable interest rate and interest rates rise, your payment will be even higher and could change over the life of the loan.

What do I need to think about before I decide to take an IO loan?

You need to look at both what you can afford now and what you expect to be able to afford in the future before deciding on whether an IO loan is right for you. Consider the following:

Income: What is your income now and what do you expect it to be three, five, or 10 years from now, when you will have a larger loan payment? How will you afford the larger loan payment if your income does not change, if you lose your job, or if your income is lower in the future?

Interest rates: If your IO loan is adjustable rate, and you have calculated that you can afford the higher payment as long as interest rates stay low, how will you keep up with payments if interest rates are higher in the future? What is the maximum interest that you can be charged under the terms of the loan? Can you afford that?

Home value: Right now, New Jersey home values are high. That does not mean they will stay high. A negative change in the economy could result in lower home values. Your house could be worth less in five or 10 years than what you paid for it. If you have an IO loan, this means that, in the future, you may owe more on the loan than what your house is worth at that time. You might not be able to sell your house for a high enough price to pay off the principal on your IO loan. You would no longer have the house, but you would still owe money on the loan.

IO loans have their place in the home loan market, but they might not be the best choice for you. If you know for a fact that you will have higher income when higher loan payments are due, there may well be an advantage to purchasing or refinancing with an IO loan. If you have funds available to make payments towards the principal before you need to, an IO loan may work for you, since you can make an additional payment in the months when you have extra cash. And an IO loan might work for you if you are absolutely, positively sure that your home will be worth as much or more in three, five, or 10 years than what it is worth today.

Take the time to ask yourself, “Am I really sure about that?”

This article appeared in the October 2005 edition of Looking Out for Your Legal Rights^®.

This information last reviewed 2/24/10.