Can an interest-only loan cost less than a traditional loan if I make extra payments?
Q. In comparing a 30-year, fixed-rate loan at 6% with a 30-year, interest-only loan at the same rate, I was told that you would actually save money in total interest paid if you chose to go with the interest-only loan and made payments to principal each month. Is this true?
A. It's true if the extra principal payments you made each month were big enough.
An amortizing loan such as a fixed-rate, 30-year mortgage establishes a monthly payment for the life of the loan. Part of that payment covers the interest charge and the remainder goes to pay down the principal. Since the interest is based on your monthly balance, the portion of your payment needed to cover the interest declines and the portion devoted to repaying your loan steadily increases.
Let's say you use a traditional 30-year loan to borrow $150,000 at 6% interest. Your payments would be $899 a month and the first payment would devote $750 of that to interest and $149 to reducing your principal.
The second month your interest charge would drop to $749 and your principal payment grow to $150 because you had repaid part of what you owe. By the end of the fifth year of this loan you'd be paying $699 a month in interest and $200 in principal.
Now let's say you borrowed the same amount, at the same rate, using a five-year, interest-only loan. You'd be allowed to pay just the interest for the first five years but then have to pay the interest and repay the entire principal over the next 25 years.
Your monthly payments for the first five years would be $750, same as the initial interest charge on a traditional loan. If you voluntarily paid more than $750, all of the extra money would be applied to the principal. If your total payment was consistently more than $899 a month, then you'd be paying off the debt more quickly than if you were paying the required $899 on the traditional loan.
But we wouldn't be surprised if your question originated with a sales pitch for an interest-only loan. You are concerned that an interest-only loan will cost you more over the life of the loan. And it will.
Using our examples, you'd pay $173,700 in interest on the traditional loan and $184,900 on the interest-only loan if you kept them for 30 years.
Suggesting that you can reduce that cost by voluntarily paying down the interest is meant to make you feel better, not provide a real solution to your concern. Most of us would find it very hard to sit down month after month and write a bigger check than we absolutely must to our mortgage company.
We almost always encourage buyers to go with traditional loans. If you have to use an interest-only loan to afford the payments on the house you're going to buy, you probably can't afford the house.
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