Interest-Only Mortgages and Amortization

Interest-only mortgages are a relatively recent phenomenon, at least as currently constituted. There are no interest-only mortgages that stay that way for their entire term. Instead, current interest-only loans require interest-only payments for a fixed initial period. After this period, payments are recalculated to be fully amortizing.

To sell interest-only mortgages, many loan officers make claims about them that involve the way their amortization is set up. One of these pitches claims that an interest-only mortgage allows faster amortization, the other claims that borrowers can save money through foregoing amortization.

The first pitch works by taking advantage of the fact that interest-only mortgages are equipped with a low initial rate. The theory is that these lower rates will allow you to make the same payment you would with a fixed-rate mortgage, but more of it will be applied to the loan’s principal, causing the loan to be paid off sooner than anticipated.

Technically, this is true. For example, if your lower rate on an interest-only loan made your payments $200 less than a comparable fixed rate mortgage, you could apply the entire $200 directly to your principal each month.

However, this claim ignores key facts. The lower rate received with the interest-only loan comes not from its interest-only status, but the fact that is an adjustable rate mortgage (ARM). The loan officer’s pitch may deflect attention from this fact, and cause borrowers not to consider the risks inherent with ARMs.

Borrowers who feel they would benefit from the strategy should consider the risks of ARMs. If they still like the idea, they might actually be better served by getting an ARM without the interest-only option at a lower rate. They can still apply the difference in their monthly payments directly to the principal in this case.

The other common pitch claims that the money saved each month from a no-interest loan would get a better return when invested in other areas, rather than being used to pay down your loan’s balance. This idea is much more straightforward, though in reality it does not work for most borrowers.

In both cases, borrowers are advised to dig deeper into the relationship between amortization and interest-only mortgages, rather than simply believing the claims of their loan officers.