Frisco Texas Residential

"I realize that I don't pay principal on an interest-only (IO) mortgage. I chose it because it is important to me to keep the monthly payment down. Yet I get a bonus every year. Would a large payment at year-end make up for the monthly principal payments I do not make during the year?"

Yes, in the sense that there is a payment amount that, if made at the end of the year, would leave the balance exactly where it would be if you were making the fully amortizing payment every month.

For example, if you borrow $200,000 at 6 percent for 30 years, the fully amortizing payment is $1,199. This is the amount that, if paid every month, would pay off the loan in 30 years. The interest-only payment is $1,000, or $199 less. If you pay $1,000 for 12 months, you must add an extra $2,456 to the payment in month 12 to reduce the balance to what it would have been had you paid $1,199 for each of the 12 months. This payment strategy – paying only the interest for 11 months followed by a large payment in month 12 – is thus doable. I found the $2,456 in the example very easily using the extra payments spreadsheet on my Web site, and you can too.

BUT: the payment to principal at year-end is larger than the difference between the fully amortizing and the interest-only payments over the year. The monthly payment difference of $199, when multiplied by 12, equals $2,388. This is the sum of the principal payments you would have made if you had not selected the interest-only option. It is $68 less than the $2,456 payment required at year-end to make up for the absence of monthly principal payments. The $68 is the penalty for delaying the principal reduction.

You might well decide that this is a small price to pay for the convenience of being better able to match your payments to your income. The greater flexibility, however, means less discipline. Without the IO option, you must make the fully amortizing monthly payment, but the year-end payment of principal when you take an IO is voluntary. It is going to be so easy to spend that money differently!

Author Information

Jack Guttentag