Fixed-rate vs. interest-only mortgages
A fixed rate mortgage has a fixed mortgage rate for the entire term of the loan. Typically, a fixed rate mortgage has a 15- or 30-year term. Payments for a fixed rate mortgage are amortized over the term of the mortgage so that principal and interest payments are made so that the mortgage is completely paid off at the end of the mortgage term.
Interest- only ARMs are adjustable-rate mortgages, which usually have a fixed rate for a certain length of (usually 5, 7, or 10 years), after which the rate begins to periodically adjust to reflect market interest rates.
ARMs are typically described by the number of years the rate is fixed, and then the frequency the rate adjusts. So an ARM that has a fixed rate for five years and then adjusts every year after that would be a 5/1 ARM. One that is fixed for seven years and then adjusts every two years would be a 7/2 ARM.
Interest-only mortgages are a special type of loan in which you are not required to make any payments toward the loan principle – you only pay the interest charges as they arise. This is not an open-ended deal – eventually you have to repay the principle, either as a single lump sum "balloon" payment or by switching to a fully amortizing loan schedule. But for that length of time, they allow you to make very small loan payments compared to a fully amortizing loan.
Here are some of the more common situations where borrowers use an interest-only mortgage:
- As a construction loan to cover the cost of the property and home construction, converting to a fully amortizing loan when the home is completed
- By high net worth borrowers who don't want to tie up their capital in a residence, and are content to periodically refinance into a new interest-only loan.
- For borrowers who are looking at the property as an investment, plan to sell it within a few years and want to minimize expenses.
These days, interest-only home purchase mortgages typically require a substantial down payment and excellent credit. While interest-only ARMs were once popular with cash-strapped borrowersof modest means seeking to maximize their purchasing power, that type of lending has long since dried up.
Fixed Rate vs. Interest Only Calculator Overview
The calculator will show what your monthly payments would be for all three loan types: fully amortizing fixed-rate, fully amortizing ARM and interest-only ARM. It will also show you the total interest costs for the three loans and amortization schedules for all three.
Enter the information for each loan. Note the following:
- The mortgage amount and term in years entered under "fixed-rate mortgage" will be used for all three loans
- The "months rate fixed" is how long the ARM will remain the same rate before adjusting.
- Expected adjustment: The calculator assumes the rate will adjust annually after the fixed-rate period ends. Note this can be a negative figure as well as positive.
- Interest rate cap: the highest the interest rate is allowed to go during the life of the loan
- Clicking on the descriptions of each entry item will provide definitions and further explanations.
When you have entered all your information, click "Calculate" and then "View report" for a comparison of the three loans and amortization schedules.