I recall a few years ago when a certain national lender offered a mortgage loan that let the borrower make a choice of whether or not to pay any principal. Just interest. It hit the markets with a resounding splat. No one was interested. “You’re wasting your time” they said. “You’ll never have any equity” they said. “It’s only good for the lenders, why do you think they’re pushing it?” they said. Well they’re not saying it now.

Interest-only mortgages, while having been around for quite some time, are catching steam. Most lenders offer some version of the product, while others underwrite to a loan designed by Merrill Lynch or Bear Stearns. Whatever your flavor, the Interest Only mortgage is something you might want to review.

When compared to a mortgage that’s fully amortized, an Interest Only loan simply calculates simple interest on the loan amount and provides you with a monthly payment. A fully amortized loan takes your loan amount, your interest rate and a predetermined payback period to calculate your monthly payment. That payback period is usually characterized by a 30 or 15-year period. A fully amortized fixed loan over 30 years fixes the monthly payment you make for the entire loan term until the loan is retired. Each payment contains some directly toward your loan balance some to the interest.

But an Interest Only loan let’s you determine how much, if any, principal you’ll pay down. On a fully amortized loan, those principal payments are predetermined unless you make additional principal payments. But at the beginning of every fully amortized loan, very little goes toward the principal. Most goes to the lender in the form of interest payments.

On a $100,000 mortgage loan over 30 years, a 6.25% rate yields a $615.00 payment. $520 goes toward interest and a whopping $95 goes to your principal. As the loan progresses, more each month goes to principal and less to interest, but it takes an awfully long while to reach a balance where the payment is equally divided between principal and interest. In this instance, you’d have to wait almost 19 years until principal and interest payments are about the same.

And in five years’ time, you’ve only paid your $100,000 mortgage to $94,100. Doesn’t seem like much, does it?

For a $100,000 loan and 4.00% simple interest, the monthly payment is $333. Yes, that’s lower and yes, you’ll never pay down your mortgage. That is unless you make extra payments every month. Let’s increase your monthly payment by $200, giving you a monthly payment of $533, lower than a fixed payment. But instead of a microscopic $95 going to your principal, you’re paying it down twice as fast.

In this example, after five years the principal balance is $88,000, not $94,000. Pretty fast, huh?

Interest Only loans are certainly not for everyone. Such loans are variables, and can rise or fall every month. Some have caps at 12%, much higher than any fixed rate today in the 6% range. But if you’re looking shorter term, or like the flexibility of making principal payments when you feel like it, look into the Interest Only loan. It’s quite a product.

Published: July 26, 2002

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, a veteran Mortgage Banker, successful Real Estate Consultant and author of Your Guide to VA Loans, Mortgages 101: Quick Answers to Over 250 Critical Questions About Your Home Loan, Who Says You Can't Buy a Home!, and Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You, is a former columnist and Contributing Editor with San Diego-based Mortgage Originator Magazine. Reed is President of CD Reed Mortgage Bankers, Austin, TX and is a Past President of the Austin Mortgage Bankers Association.