Interest-only loan

Key Takeaways

• During an interest-only period the loan balance does not go down, because none of the payment is applied to principal.
• When the interest-only period ends the borrower has to pay the balance off, refinance, or start making higher payments that include principal.
• An interest-only feature is not the same as negative amortization; with negative amortization the balance grows.
• A loan with an interest-only period cannot be a qualified mortgage under the federal ability to repay rules.

What It Means

An interest-only loan is a mortgage whose scheduled payment, for a set opening period, covers the finance charge and nothing else. The lender is paid for the use of the money and the amount borrowed sits exactly where it started. A $500,000 loan at 7 percent runs about $2,917 a month in interest alone, and after five years of those payments the borrower still owes $500,000.

That is the trade. The payment is smaller than a fully amortizing payment on the same balance, so the borrower keeps cash now, but no Amortization is happening and no equity is being built by paying down debt. Any equity has to come from the property gaining value.

The interest-only period always ends. When it does the borrower has three ways out: pay the balance in a lump sum, refinance into a new loan, or begin making payments that include principal, which are higher than the interest-only payments were. That third path is the most common, and the jump is usually steep, because the same principal now has to be repaid over fewer remaining years. A borrower planning to refinance instead is betting that their credit, their income, and the rate market will all cooperate on a date picked years in advance.

How It Works in Washington

Interest-only mortgages are legal in Washington, and the state regulates them through disclosure and supervision rather than a ban. Chapter 19.144 RCW, the mortgage lending and homeownership act, is where to look. RCW 19.144.030(1) requires the state to "apply the interagency guidance on nontraditional mortgage product risks and the statement on subprime mortgage lending to financial institutions," and RCW 19.144.030(2)(a) requires those institutions to adopt internal policies aimed at the same objectives. That federal guidance says in its own words that nontraditional mortgage loans "include both 'interest-only' mortgages, where a borrower pays no loan principal for the first few years of the loan," alongside payment option adjustable-rate mortgages.

What Washington does ban is the next step down. RCW 19.144.050 provides that "a financial institution may not make or facilitate a residential mortgage loan that includes any provisions that impose negative amortization and which are subject to the interagency guidance on nontraditional mortgage product risks and the statement on subprime mortgage lending." Interest only holds the balance flat and is allowed. Negative Amortization lets the balance grow and is not.

Disclosure runs on a three business day clock. RCW 19.144.020(1) bars making a residential mortgage loan unless a plain language "disclosure summary of all material terms" reaches the borrower "within three business days following receipt of a loan application," and RCW 19.144.020(2) requires that summary to state the interest rate, fees and discount points, whether the loan carries prepayment penalties, and whether it contains a Balloon Payment. Our rundown of loan types every Washington broker should know and our piece on prepayment penalties cover the neighboring terms.

Example

Owen and Maya Brackett buy a Bellingham house for $1,150,000 with an $862,500 loan at 7.0 percent fixed, interest only for the first ten years and then fully amortizing over the remaining twenty. Their income is commission-based and uneven, so the smaller opening payment appeals to them. Interest only, the payment is $862,500 times 7 percent divided by 12, which is $5,031.25 a month. A fully amortizing 30 year payment at the same rate would have been about $5,738.

They make the smaller payment for ten years and pay $603,750 in interest over that stretch. On the first day of year eleven they still owe $862,500, exactly what they borrowed. The loan then recasts, and the same $862,500 repaid over twenty years at 7.0 percent runs about $6,686 a month, a jump of roughly $1,655. Because of the interest-only feature the loan is not a Qualified Mortgage under the federal ability to repay rules, a point their loan officer flagged in writing at application.

Common Mistakes and Exam Traps

• An interest-only loan does not automatically require a balloon payment. Many recast into higher fully amortizing payments instead, and refinancing is a third option.
• Interest only keeps the balance flat. Negative amortization makes the balance grow, and Washington bars negative amortization on covered residential mortgage loans (RCW 19.144.050).
• A smaller interest-only payment is not a lower interest rate. The rate can be the same or higher; the payment is smaller only because no principal is included.
• A loan with an interest-only period cannot be a qualified mortgage under the federal ability to repay rules.