IO's: Low Interest Loan with High Risk Costs


Defined Tag: Low Interest Loan.

At first glance, an interest only loan, or IO, would seem to be the ideal low interest loan; for a period of five or ten years, you pay nothing but interest costs (which, on a low interest loan, can be almost nothing in comparison with traditional mortgages), thereby lowering your payments and making it possible to purchase a more expensive house than you would have been able to afford, otherwise. But let's stop just a moment and see whether this low interest loan is really all it's cracked up to be.

The thing about a mortgage payment is that you have two figures you're dealing with; first, the cost of the house; second, the cost of the interest. Traditional mortgages start off as mainly interest with a small part of your monthly payments going towards reducing principle--that is, the cost of the house--but as the principle is gradually lowered, the actual amount of interest you're paying each month begins to decrease, so that more of your payment goes towards principle. The result is a kind of snowball effect that, especially with fixed rate mortgages, pays off your home in slow but steady segments; no nasty shocks, no rude surprises.

With an interest only loan, however, you're paying only interest for the first five to ten years. That tiny bit of payment on principle (which gradually increases to a large payment on principle as more of the principle is paid off and interest payments become smaller) is missing--which leads to a short term gain, but, perhaps, a long term loss. Because, you see, at the end of those five years, *you still have the entire payment to make*, only now you have only 25 years to spread payments over, rather than 30 or 35 years. This is bad news for most homeowners, even if you have a low interest loan. This means a huge jump in payments, and it should cause most people to think long and hard about whether this kind of loan, low interest loan or not, is right for them.