More specifically, the seemingly common misconception that interest-only loans are in any way tied to negative amortization. There is a difference, and I think it’s an important one to understand.
Interest Only is…well, Interest Only
I meant what I said & said what I meant
I hesitate to over-simplify anything in the world of home finance, but Interest Only means exactly that:
Your payment is comprised of only the interest on the loan.
That means you are not paying any principal on the loan. Your payment only covers the interest.
However, it is important to note that the payment does cover the interest. This stands in stark contrast to a negative amortization loan, which is what I think most people actually have in their minds when they hear the words “interest only”.
Mistaken Identity
The “bad guy” most people are thinking of when they scoff at Interest-Only loans is actually negative amortization. To simplify what “negative amortization” means, let’s just call it a minimum payment.
The problem with this minimum payment is that it doesn’t even get close to the interest. Let’s illustrate with a generic example.
Say you got a negative amortization loan with an interest rate of X. If you made your payments based on the rate of X, you would have nothing to worry about. However, this loan features the option to make a minimum payment based on a rate of X – Y: an option that you take advantage of.
This is where the fun starts.
The bank doesn’t just write-off the difference between X and X – Y. Somehow that deficiency needs to be made up. This is accomplished by adding the difference to your principal loan amount. In other words, whatever you didn’t pay in interest this month is added to the amount you will repay over the life of the loan.
that'll be one million dollars
With many of these loans, you had the option to pick your payment every month. You could make the minimum payment, make a payment based on a 30 yr or 40 yr fixed, etc. These loans were also adjustable rate mortgages. So, once a year, your true interest rate was adjusted.
These loans were called “Option ARMs” frequently. They got a lot of people in trouble, yada yada yada, mortgage crisis.
To my knowledge, these loan products are no longer offered by mainstream lenders.
Interest Only are offered by major lending institutions. Enter the confusion.
I blame the media
In its exuberance to assign blame for the mortgage/credit/economic collapse of late, the mainstream media got a lot of things…well, wrong. I have no evidence to support my contention that the media is at fault in this particular instance.
However, I can’t imagine too many scenarios in which large swaths of people have the same misconception that don’t involve the media, to one extent or another.
This is an excellent example of why I started this website. I got tired of yelling at the TV when the mortgage industry at large, and the crisis in particular, were being “reported” on.
If you have any questions about something you’ve heard in the media, please leave a comment at the bottom, or use the following no-spam-guaranteed contact form.
