Interest Only Home Equity Loans: How do the Loan Terms Work?

Most of us have heard of home equity loans. You know, refinancing your home for a second mortgage to pull out some extra cash for home improvements or bill consolidation. But, did you know you could refinance your home and actually pay less on your mortgage every month? If you are planning to stay in your home for less than ten years or need some time to stash away some much needed savings, an interest only home equity loan might work for you.
Home equity loans and credit lines usually have variable time periods ranging from three to ten years. After the initial period is complete, the loans convert into a full amortized loan. Here's an example: In a traditional loan, each monthly payment includes interest and principal. After five years of traditional payments, the balance of a $100,000 home would show as $93,054. A 10 year interest only loan requires only an interest payment for the first ten years. After ten years of regular interest payments, the principal remains at $100,000. The loan is then re-amortized and regular payments are made.
"An interest-only home loan may also be a good option for people who expect to be in their homes for less than ten years. The average homeowner stays in their home between five and seven years. As mentioned before, home mortgage payments are mostly interest for the first years of the loan. Many homeowners like the option of making interest only payments and using the extra money as they please- save for college tuition, make home improvements, or buy a much-needed new car."

If you plan on selling your home before the interest only time period, no harm no foul. Keep in mind the interest during the interest only portion of the loan is fully deductible according to the IRS. But, remember after the initial period of ten years the principal balance has not changed. Some lenders up the interest on the loan and you might get stuck with a mortgage payment even higher than had you financed a more traditional loan.
The Los Angeles Times ran a feature article by Jack Guttentag about interest only home equity loans. "In the 1920s, loans of this type were the norm; borrowers typically refinanced at term. But the Depression of the '30s caused many to go into foreclosure, and lenders stopped writing the loans." But Guttentag also writes that the interest only loan is not always the smart investment. "Suppose you have a 6.25% mortgage and your financial plan calls for increasing your wealth this month by $100." If you put it in the bank, you may earn 2% to 4%. If you put it in bonds or stock, you may earn more but you take a risk. If you use it to reduce the balance of your mortgage, you earn 6.25% with no risk at all.
The tax saving on mortgage interest does not affect such comparisons because you must pay taxes on interest earnings. Suppose you are in the 39.1% tax bracket. Then your 6.25% mortgage costs only 3.81% after taxes, but a 4% CD yields only 2.44% after taxes. "The investment that is most advantageous before taxes is also most advantageous after taxes." Bottom line is that an interest only home equity loan is a smart choice for homeowners with high market value (HMV) planning to sell before the interest only period expires. If you choose an interest only second mortgage as a financial strategy for increased earnings, make certain the interest you earn elsewhere is worth the added interest when the interest-only loan converts.
Tip! A 125 percent equity home loan is a second mortgage loan that allows you to borrow up to 25% more than the value of your home. For example, if your home is worth $100,000 and you owe $100,000 on the mortgage, this loan program would allow you to still borrow up to $25,000.
Nick Rian is an award-winning journalist whose journalism credits include awards from the Associated Press, Wisconsin Broadcaster's Association and The Milwaukee Press Club. Today Nick publishes loan articles in San Diego California. You may find more information about home refinancing, and read more of Nick's articles at BD Home Equity Loans. You can get more advice for first time home buyers and 125% home equity loans and get more information about and refinancing for people with all types of credit. Look for great interest rates on home equity credit lines and second mortgages with no application fees.