There has been a great deal of talk about interest only loans, but no one has really explained what these new methods of financing are. Well, by the time you read all the way through this article, you should know what an interest only loan is an why they can be very dangerous. And the best part is you get to participate!
First, get a piece of paper and a pencil. Now, draw a rectangle. Now draw a straight line from the upper-left hand corner of the rectangle to the lower-right hand corner of the rectangle. You now have a rectangle divided into two triangles. Along the bottom of the rectangle write the label “time” and along the vertical side write “amount of money”.
Congratulations! You have now successfully diagrammed a standard mortgage cash flow! Pat yourself on the back on a job well done. Now, let’s explain the components of this thing by comparing it to a standard bond payment.
Here is a good place to explain the difference between a mortgage and a traditional bond payment. When someone gets a loan in the form of a bond, they make interest payments on a regular basis and repay the amount of the loan (the principal) at the end of the loan term. For example, suppose you sell a $1000 face amount bond at 10% interest for 10 years. The $1000 is the face amount of the loan, or the actual amount of money you are borrowing. This is also called the principal amount. The interest is the cost of the loan, or the price you pay to the lender for using the lender’s money. Over the 10-year life of the bond you will make annual interest payments in the amount of $100. But, when you make these interest payments, you don’t repay any of the principal or the amount of the loan. Instead you repay the lender the cost of the loan and save repaying the principal for the last payment.
To compare the above bond payments to a mortgage, we’ll return to our rectangle diagram. The lower triangle represents the interest component of the cash flow and the upper triangle represents in principal component of the cast flow. Now, remember the horizontal line represents time. So every time you make a mortgage payment, you pay a particular amount of interest and a particular amount of principal. At the beginning of the loan, you pay mostly interest and a little principal. At the end of the loan, you pay mostly principal and a little interest. This process is called amortization, or the process of dividing a particular stream of payments into interest and principal components over a particular period of time.
Now, notice with the standard mortgage diagram, you are paying a combination of interest and principal. Every time you make a payment, you are whittling down the face amount of the loan. So in year 10 of a 30-year mortgage, you should theoretically have a smaller face amount due to the lender.
With an interest only mortgage, you are only paying interest for the first part of the loan. While you are paying only interest, the principal amount remains unchanged.
Let’s use some numbers to illustrate this point. I’m going to use simple numbers that don’t represent actual amounts in order to make the illustration easier to understand.
Suppose you take out a $100,000 30-year mortgage at 10%. With a standard mortgage by year 10 you have repaid say 1/3 of the principal, or $33,000. However, by year 10 of an interest only loan you still have $100,000 outstanding on the loan. This is where the problem comes in with interest only loans. At some time in the future, the debtor may get hit with a massively escalating financing payment that will not go down.
This is an overly simplified version of the real thing, but the core principles are the same. Interest only loans make a traditional mortgage borrower more like a corporate borrower and making him more subject to the same problems as a corporate borrower.