Interest Only Second Mortgage loans are a great way to lower your mortgage payment while freeing up extra cash each month.
A second mortgage is “interest only” if the scheduled monthly mortgage payment – the payment the borrower is required to make --consists of interest only. 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 to.
If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged.
For example, if a 30-year loan of $100,000 at 6.25% is interest only, the required payment is $520.83. In contrast, borrowers who have the same mortgage but without an IO option, would have to pay $615.72. This is the "fully amortizing payment" – the payment that would pay off the loan over the term if the rate stayed the same. The difference in payment of $94.88 is “principal”, which go to reduce the balance.
Only Second Mortgage FYI
Interest-only second mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences.
Pay Principal When Convenient: Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial payment to principal.
Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to.
Buy More House: It is common for families to begin with a "starter house", then move into a more expensive house as their incomes rise. This process of "trading up" carries high transaction and moving costs.
You can avoid these costs by skipping to the second house now. In the short term, this will cause a cash flow strain, but the IO mortgage may make it manageable.
Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize.
Invest the Cash Flow: For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.
A valid example is the young borrower with a long time horizon who invests in a diversified portfolio of common stock. This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return investing in their own businesses.
Ask yourself whether you really will invest the excess cash flow, as opposed to spending it; and whether you have a firm basis for believing that your investments will yield a return higher than the mortgage rate.