Myth: Paying extra on an interest-only loan pays down your loan faster than a standard amortizing loan.
FALSE! If you pay extra on any mortgage, you’ll pay it down faster. But if you have a mortgage with an interest-only option and you make the same payments as you would on a standard amortizing mortgage, it will pay down at the same rate as the amortizing loan.
Let’s take an example: Person A has an interest-only loan and Person B has a fully amortizing loan. Both loans have the same interest rate. If both people make the same monthly payment, then the loans become identical because they will both pay down at the same rate. The only difference between the two is that Person A has the choice to pay less if he wants to in any given month. Person B doesn’t have that choice.
Interest-only loans allow people to pay only the interest or interest plus as much principal as they wish; even extra if they want. But the reason people get interest-only loans is to have the payment flexibility when they need it. Instead of paying principal on your loan, you may want to use it for other things such as saving for your child’s college tuition or investing in other things that bring a higher rate of return. Another good way to funnel your money is to pay off high-interest credit card debt.
However, if you pay extra toward your interest-only loan (that is, more than the monthly principal and interest payment), one good thing that happens is the next month’s required payment drops. So, for example, if a homeowner has a $200,000 loan with an interest rate of six percent, his interest-only payment would be about $1,000. Let’s say this homeowner received a $50,000 inheritance and used it toward his mortgage. He’s just decreased the monthly payment for the following month to $750. If he had a traditional amortizing mortgage, his payment might be $1,200 and he could still pay down his mortgage faster, but the monthly payment would still be $1,200.
Having the option to pay less on your mortgage is a powerful and very useful option. If you choose to pay extra, you can. If you have a traditionally amortizing loan, you can’t choose to pay less and that’s the difference–choice.
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