Normally, your monthly payments do not include anything to be paid towards the principal during the interest-only period of your mortgage. On the one hand, it makes these payments lower; on the other hand, when the interest-only period is over you have to face the debt you borrowed years ago in its full size again, only now you have a shorter period of time to repay it. That is why it is strongly recommended to make voluntary extra payments towards the principal during the interest-only period, if your lender allows you to. If he does, make sure the outstanding balance gets adjusted immediately after an extra payment is made. Sometimes a special arrangement for extra payments during the interest-only period is included into the mortgage contract. If you are only planning to take out an interest-only mortgage and intend to make extra payments, pay special attention to these details in your contract. The problem is that many lenders do not adjust the balance during the interest-only period at all, with or without extra payments, unless stated explicitly otherwise in the contract. If the balance gets adjusted (becomes smaller), the amount paid as interest (percentage of the outstanding balance) becomes smaller, too. This way your monthly interest-only payments become even lower (provided the rate is unchanged or drops). If the first adjustment will take place only after the interest-only period is over, all the monthly payments during the interest-only period remain unaltered. It does not mean that you will eventually pay more as interest, though. Everything will be recalculated, your extra payments, as well as the overpaid interest, will be subtracted from the balance, when the time comes. The tricky part here lies in the investment opportunities available to you at the time of your extra payments. It may so happen that an alternative investment would have brought you a better return, if you had invested into it, rather than the mortgage, whose return you will see only in a few years.

For more on Interest-Only Mortgages read here.

The reasons for that can be:
i) If your have a conventional fixed-rate or adjustable rate mortgage, and it is really as young as 2 years, it is natural for the balance to reduce insignificantly because of the “leveling” of monthly payments. You can find a more detailed explanation in my article about FRMs; but in short, in early years each monthly payment pays mostly towards the interest. Only in later years the monthly proportion of money paid towards the principal increases and then the reduction of the outstanding balance becomes more noticeable. The principal payment is always a remainder – the total monthly payment minus the interest; and if with a FRM everything is pre-calculated and the monthly amount is set, ARM monthly payments change to meet the new rate and serve, first of all, the interest; the principal gets the residual. Generally, this case presents nothing to worry about.
ii) If the balance is totally unchanged, you probably have an interest-only mortgage, i.e. everything you pay every month is paid towards the interest only.The balance will start to reduce only if you make an extra payment or when the interest-only period is over. For more details on Interest-Only mortgages read here.

 First of all, Interest-Only is not a separate mortgage type. It is an option that can be attached to virtually any mortgage repayment plan enriching it with its benefits or disadvantages (or both). Interest-Only has different effect on different plans, but it practically always makes the overall cost of a mortgage higher, as well as brings certain quite pressing issues into the sums to be paid monthly when the interest-only period is over. Always study the advantages you buy at the price thoroughly – they have to be really worth it.

The idea of the Interest-Only option is that your monthly payment pays in fact only the interest. You sort of pay some “salary” to the lender for using his money, but it remains his money anyway, as well as your (still potentially your) home remains his, too. No mortgage is 30 years interest-only nowadays, so eventually you are expected to start paying the principal off – only at that stage you will start to really buy out your home.

The interest-only option can be attached to both a Fixed Rate Mortgage and an Adjustable Rate Mortgage. The interest-only period does not usually exceed 5 years. After that, you should be able to start making regular (interest + principal) monthly payments.

With a Fixed Rate Mortgage the amount of monthly payments remains the same throughout all the 5 years of the interest-only period, because the rate is fixed and the principal is unchanged, unless you make extra payments.

With an Adjustable Rate Mortgage, however, monthly payments have to be adjusted to keep up with the changing rate. The interest-only period of an Adjustable Rate Mortgage does not imply by default that the rate will stay fixed all through the time, unless you make a special arrangement for that, most likely, at the cost of the general rate increase. The balance of the loan remains the same, if you make no extra payments, but the rate changes according to the index and other provisions stated in the contract, so the payments have to be adjusted regularly, too.

Now, about the extra payments, I mentioned above. In theory, every time you make an extra payment, its amount should be subtracted from the loan balance, and the next after the extra payment month should already claim a lower interest-only amount, recalculated on the new lower balance. In reality, it is not always the case. If you expect, that you will be able to pay extra from time to time during the interest-only period and you want the appropriate changes to take effect immediately, make sure the monthly adjustment is in your contract. Otherwise, the adjustment will only take place at the regular adjustment time with an Adjustable Rate Mortgage, and may not take place at all for as long as 5 years with a Fixed Rate Mortgage. I don’t mean to say that your money will be lost or wasted completely in that case, but it will not show its return as soon as you may want to expect it. If you, for example, make your extra payment in month 2 of the interest-only period of your Fixed Rate Mortgage, the effect of this payment, unless stated otherwise in the contract, will become apparent only in 5 years, i.e. when the interest-only period is over. As you come to the stage of paying both the interest and the principal, you will probably be pleased to find out, that your balance has declined due to your years-ago extra payment, but at what price? It may so happen that the same money deposited in a bank rather than paid for the mortgage could have gained you a much better return through these years.

When the Interest-Only period is over, you are expected to be able to start regular (interest + principal) monthly payments according to your mortgage plan to amortize the loan completely. This is the hardest part, because with, say, no extra payments made during the Interest-only period, you now have to face the full balance as it was at the loan origination to repay within even a shorter period of time than the original term. This is the price you pay…

An Interest-Only mortgage, however, can be helpful to people, who want to buy a home now, but lack immediately adequate financial resources. If you are sure that your income will rise in 5 years to the extent that the new monthly payments will not ruin your family budget – the Interest-Only option can be for you, too.

Another situation quite appropriate for an Interest-Only may occur when people start a business of their own and mortgage the property, where the business will run. The money saved on the loan payments can be invested into the business early development.

A mortgage will become your biggest debt in years! For most people it is true, but it not as scary as it may sound. When you have the knowledge, when you understand what exactly is going on, when you are in full control of the situation – trust me, it is not scary!

I am here to share all the knowledge of the matter I have, with you.

We’ll start with the general idea of the most frequently used mortgage programs.

The two fundamental types of mortgages are the Fixed Rate Mortgage and the Adjustable Rate Mortgage. They both are amortized mortgages, which means that you have to repay the money you borrow (the principal) plus the interest on this money. As the name suggests, the Fixed Rate Mortgage provides the comfortable stability of a fixed interest rate – no matter what, you always know that you will not wake up one day to find out that your debt has unexpectedly doubled. If you have a stable job and your income flow is smooth and steady – this kind of mortgage can be for you. The only problem is that its Interest Rate may be higher than the Interest Rate of an Adjustable Rate Mortgage. You have to pay for the comfort, but it may be well worth it, if you don’t feel very adventurous about your finance.

An Adjustable Rate Mortgage usually looks very appealing in the beginning – the lenders use this trick to attract more customers, but later on the Rate can be changed and, as you understand, there are extremely few, if any, lenders ready to make the rate lower, so it will go up. However, the probability of you waking up to a doubled debt even with this type of mortgage is next to impossible either. There are laws and regulations about adjustable mortgage rates, protecting both the borrower and the lender. First of all, in the very beginning you can have the Rate fixed for as long as several years (the longer this period – the higher the Rate). Next is the Interest Rate Cap – the limit of the Rate increase. Moreover, the increase of the rate is not the personal whim of the lender. The rates are determined by several macro-economical indexes, which, in fact, are not controlled by the lender in any way, or by anyone at all, except for His Majesty Market.

All other types of mortgages are basically variations and derivatives of these two. The number of the variants is practically unlimited, which is good, because you will always be able to find a program to satisfy your needs and budget.

For example, an Option Adjustable Rate Mortgage adds a lot of flexibility (and complexity) to a conventional Adjustable Rate Mortgage. Every month you are given a choice of payment options: you can pay an amount equal to a period payment of, say, an interest-only mortgage with your actual interest rate, or as if your Interest Rate were 1%, or some other combination. The Interest Rate can be adjusted any month, too. This mortgage plan can be perfect for people whose income is not even all the year around. The only thing that is fixed in this mortgage plan is the minimum amount of a period payment, which, as usual, is very attractive in the beginning, but beware – it tends to increase with time and may actually result in an amount virtually impossible for you to pay.

Fixed Rate Mortgages may have an easier mechanism, but it does not mean they lack options. The most common of them is the so-called Balloon Mortgage. It’s a sort of a cross-breed of a fixed rate and an adjustable rate mortgage. On the one hand, the Period Payments are calculated on the same basis as, say, with a 30-year Fixed Rate Mortgage, but the actual “balloon” term is considerably shorter. Usually, after 5 or 7 years the Balloon Mortgage has to be completely repaid, which forces the borrower to either pay off the remainder of the balance himself at the end of this period of time or refinance at a new interest rate. The new rate, however, is not limited the way it is with an Adjustable Rate Mortgage, so you can expect literally anything. Most lenders do have common sense, though. This type of mortgage has proved to be useful to people who intend to move out of the property as the balloon period expires.

An Interest-Only Mortgage can be very helpful if you feel that actual repaying of both the amount you’ve borrowed (the principal) and the interest on it may become an unbearable burden to your budget. You may consider paying only the interest, but beware – after the 30 years of accurate repayments, the mortgaged property will not be yours! The full amount of the principal (unless you make some occasional extra payments) will still be your debt, and you’ll have to either sell your property and repay the debt or re-mortgage the property on the terms that will exist 30 years ahead from now. Most lenders, however, prefer mortgages that do get repaid, so you may find it quite tricky finding a lender ready for a complete 30-year Interest-Only Mortgage. Usually a starting period of 5 Interest-Only years is offered, but after that you will have only 25 years left to repay the Principal – the period payments will be even higher!

Quite an interesting option is the so-called Piggyback Mortgage. When buying a home, the buyer is usually required to put at least 20% of the purchase price down. Unfortunately, not every buyer is capable of doing that easily. That’s where one can count on some crucial support from a Piggyback. You mortgage 80% of your new home on the terms of your selected mortgage, and then the remainder of 20% too, as a fine addition to the major mortgage, but on different terms. You end up with actually a combination of two mortgages on the same property, with an advantage that you don’t have to put down any money of your own. This combination would make an 80/20/0 Piggyback Mortgage, i.e. 80% – your first mortgage, 20% – the secondary mortgage, 0% – your own money. Other frequently used options are 80/15/5, 80/10/10 and 80/5/15.