interest
only
mortgage
An
interest-only
loan is a
loan in
which for a
set term the
borrower
pays only
the interest
on the
principal
balance,
with the
principal
balance
unchanged.
At the end
of the
interest-only
term the
borrower may
enter an
interest-only
mortgage,
pay the
principal,
or (with
some
lenders)
convert the
loan to a
principal
and interest
payment (or
amortized)
loan at
his/her
option.
Interest-only
loans are
popular ways
of borrowing
money to buy
an asset
that is
unlikely to
depreciate
much and
which can be
sold at the
end of the
loan to
repay the
capital. For
example,
second
homes, or
properties
bought for
letting to
others. In
the United
Kingdom in
the 1980s
and 1990s a
popular way
to buy a
house was to
combine an
interest-only
loan with an
endowment
policy, the
combination
being known
as an
endowment
mortgage.
Homeowners
were told
that the
endowment
policy would
cover the
mortgage and
provide a
lump sum in
addition.
Many of
these
endowment
policies
were poorly
managed and
failed to
deliver the
promised
amounts,
some of
which did
not even
cover the
cost of the
mortgage.
This mis-selling,
combined
with the
poor stock
market
performance
of the late
1990s, has
resulted in
endowment
mortgages
becoming
unpopular.
The property
boom from
the late
1990s has
seen house
price
inflation
far outstrip
wage growth.
This has led
to many
lenders
introducing
a 'pure
interest
only' form
of mortgage,
one which
needs no
proof of a
repayment
vehicle. By
August 2007,
it was
estimated
that 29% of
first time
buyer loans
were
interest
only leading
to calls for
caution from
the mortgage
sector.
"Although
interest
only
mortgages
play a vital
part in the
mortgage
industry,
often
providing
the only
means for
first time
buyers to
hold the key
to their own
front door,
misusing
this type of
loan is
counter-productive,"
said
Moneynet.co.uk
chief
executive
Richard
Brown.
From an
investor's
perspective
Interest-only
loans are
sometimes
generated
artificially
from
structured
securities,
particularly
CMOs. A pool
of
securities
(typically
mortgages)
is created,
and divided
into
tranches.
The
cashflows
that are
received
from the
underlying
debts are
spread
through the
tranches
according to
predefined
rules, an
Interest-only
(IO) loan is
one type of
tranche that
can be
created, it
is generally
created in
tandem with
a principal
only (PO)
tranche.
These
tranches
will cater
to two
particular
types of
investors,
depending on
whether the
investors
are trying
to increase
their
current
yield (which
they can get
from an IO),
or trying to
reduce their
exposure to
prepayments
of the loans
(which they
can get from
a PO).
Many
homeowners
saw the
values of
their homes
increase by
as much as 4
times its
price in
some markets
in a 5 year
span in the
early 2000s.
Interest-only
loans helped
homeowners
afford more
home and
earn more
appreciation
during this
time period.
However,
interest-only
loans have
contributed
greatly to
creating the
current
housing
bubble
situation,
because many
borrowers
could not
afford the
fully
indexed
rate.
Interest-only
loans may
turn out to
be bad
financial
decisions if
housing
prices drop,
causing
those
borrowers to
carry a
mortgage
larger than
the value of
the house,
which in
turn will
make it
impossible
to refinance
the house
into a
fixed-rate
mortgage.
[4]
Calculating
an interest
only payment
Calculating
an interest
only payment
is very
simple when
compared to
calculating
an
amortizing
payment.
When
calculating
for a
monthly
interest
only
payment, one
simply
multiplies
the monthly
interst rate
times the
principal.For
example, the
principal on
a particular
interest
only loan is
$10,000. The
yearly
interest
rate is 6%.
Therefore,
the monthly
interest
rate is is
.5%. (6/12
=.5) To
calculate
the payment,
multiply the
.5% or .005
X 10,000
which
results in a
payment of
$50.00. This
payment is
due each
month. This
seems like a
steal, but
when applied
to the more
typical
numbers of a
mortgage,
such as a
$200,000
mortgage at
8% yearly,
the interest
only payment
would be
$1,333.33
each month.
Then, when
you consider
the payment
on a
mortgage
with the
same numbers
amortizing
over 30
years is
$1,467.53,
it doesn't
look like
the interest
only loan is
such a great
deal because
it will
never be
paid.
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