Traditional mortgages pay off a combination of principal and interest during the life of the loan. The principal is the amount that you originally borrowed. An interest only loan is one where you pay only the interest on the loan for a fixed period of time. After that time you pay both interest and principal.
There are loans with fixed rates and there are loans with adjustable. With a fixed rate loan, the interest rate doesn’t change for the life of the loan. If you take out a 30 year fixed rate mortgage payment one is the same as the last payment you make 30 years later.
The monthly payment on an adjustable rate mortgage will change over time. Usually there is an introductory period where the initial rate is fixed. After that, the rate is adjusted periodically based on an index.
So an interest only index is the index used to calculate the interest rate on a mortgage where the borrower will pay only the interest for a fixed period of time.
Common Interest Only Indexes
- Constant Maturity Treasury (CMT or TCM)
- Treasury Bill (T-Bill)
- 12-Month Treasury Average (MTA or MAT)
- Certificate of Deposit Index (CODI)
- 11th District Cost of Funds Index (COFI)
- Cost of Savings Index (COSI)
- London Inter Bank Offering Rates (LIBOR)
- Certificates of Deposit (CD) Indexes
- Bank Prime Loan (Prime Rate)
What index you use will depend on how much risk you want to take. Some indexes, like the LIBOR, are more volatile than others like the COFI. Usually lenders will give a lower margin on the more volatile indexes. The margin is the amount that added on to the index to arrive at your rate. For example if the LIBOR rate is 3.15% and your margin is 2% then the interest rate you pay is 5.15%.
An interest only loan can be a way to make monthly payments affordable but remember that you don’t the money for nothing. Eventually the bank collects. If you are willing to bet that your income will increase, this might be a good way to get into a home with low payments.
The problem with this type of loan is that you don’t build any equity. But you can solve this problem by adding some to the monthly payment. If you have the financial discipline to add the principal payments you can get a low-interest loan and still build equity.
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