Interest-Only Payment

A monthly mortgage payment only requiring interest to be paid, with no pay down to the principal balance. Balance may be due on sale, refinancing or at the maturity of the loan.

What Is Interest-Only Payment?

An interest-only payment means a mortgage where the borrower is only required to pay the interest on the loan for a specified duration. In this case, the borrower is not required to make any payments towards the principal. They can either pay the principal amount altogether at the end of the loan term or at a specified time as agreed with the lender. After the specified period is over, the lender may adjust the interest rate as per the economic and market conditions and the borrower is then required to pay both the principal and the new interest amount together. 

Interest-only payments are usually structured as a type of adjustable-rate mortgage. It is important to note that borrowers choosing this type of loan are not paying any amount towards their principal and so the loan amount is actually not going down. This can be a suitable option for people who have a steady positive cash flow or income and are confident that they can pay off the principal and any additional interest in the coming years. 

‍Why Would a Borrower Choose Interest-Only Payments?

Interest-only payments are a viable option for borrowers as the initial payments are low and the borrower is not liable to pay any amount towards the principal if he chooses not to. This allows them to keep month-to-month housing costs low. Additionally, borrowers can save good money each month and pay off the principal in one-go or in a few subsequent payments. 

People who are not looking to own a home for a long time can choose this payment method. For example, people who move frequently or people looking for a short-term investment can benefit from this. 

Does Interest-Only Payments Affect Your Credit Score?‍

Interest-only payments do not affect your credit score directly, however, if the change in the interest rate after revaluation is high and the borrower is unable to pay it, the credit score is impacted. Additionally, if the borrower cannot pay the principal amount as promised at the end of the arrangement, it negatively impacts the borrower’s credit score. 

What Is the Formula for Calculating Interest-Only Payment?‍

The formula for calculating interest-only payment is straightforward as the borrower only has to calculate the fixed annual interest rate on the loan for the fixed time period they have agreed to. For this, they can simply multiply the rate of interest with the principal amount and get the amount they will pay annually or monthly, 

For example, let’s say a borrower has taken a mortgage loan of  $5,00,000 with an annual interest rate of 8% on the principal amount for 10 years. Then, they can calculate it like this:‍

Annual interest-only payment amount = 5,00,000 x 8/100 = 40,000 

Hence, for 10 years, the borrower will pay $40,000 annually, which comes to $4,00,000 for 10 years. If the borrower wants to calculate the monthly payments then he can divide 40,000 by 12 which is $3333.33 per month, each year. 

‍What Is the Disadvantage of an Interest-Only Mortgage?

‍There are a few disadvantages of interest-only mortgage such as:‍

• The borrower does not gain any equity in his home for the initial duration as he is not paying anything towards the principal amount. 
• Once the agreed time period is over, the monthly interest amount can increase and with that comes additional payments that are required to be made towards the principal. 
• At the end of the agreement, the borrower may have to pay the entire principal amount in one go which is a big amount. 
• If the market falls, the borrower can lose any equity he has gained on his home and reduce the chances of refinance. 

Conclusion‍

While an interest-only payment may sound appealing, it is also difficult  to get approved. This type of loan is easily accessible to people with a good amount of savings, good credit report and low debt-to-income ratio. It is important for the borrower to assess the expected future cash flow to ensure they can meet the higher payment obligations and pay off the principal. 

While this can be a viable option for many, it also brings certain disadvantages especially if the economy falls. 

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