What is a loan that only pays the interest? This is a loan where only the interest is paid back each month. The principal is not paid back. The loaned money may be paid back in 10, 15, or 20 years. By making payments on the principal, a borrower can bring down the amount of principal that will be due in the future.
There are two types of interest-only mortgages: adjustable rate mortgages (ARMs) and fixed rate mortgages. A fixed-rate mortgage has a payment that stays the same over the life of the loan. ARM mortgages will start out with a fixed rate for six months. After that, the rate will go up or down depending on an index, the prime rate, or the five-year treasury rate.
A second mortgage with a balloon payment is a short-term loan with a fixed interest rate. With a balloon mortgage, you have to pay back both the principal and the interest. The monthly principal payments aren't based on the mortgage's five-year term, but on a longer amortisation period of 30 years. Balloon mortgages must be refinanced every five years at the borrower's expense and if the interest rate goes up a lot.
One of the benefits of a second mortgage with a balloon payment is that the lower monthly payments could free up money that could be used to pay off other debts or make home improvements. When a homeowner's monthly payments go down, they have more money to spend on other things.
If the mortgage with a balloon payment is due in five years and the adjustable-rate mortgage is a 5/20 loan, both loans must be refinanced in five years. The borrower has to pay to refinance the second mortgage with a new second mortgage, a line of credit, or a home equity line. There is a limit on how much the interest rate can go up with an adjustable-rate mortgage (ARM). This limit is written into the original contract.
Rates on balloon mortgages are usually lower than rates on ARM mortgages at the moment. If you were sure that rates would be lower in five years, a balloon mortgage would be a good choice. If you don't know what interest rates will be in the future, the security of knowing what the highest rate can be in five years would be worth the slightly higher cost of an ARM mortgage.
Both of these second mortgage loans can go behind a negative amortisation loan in first position, as long as the broker or lender allows the deferred interest loan. Check with your home equity lenders to see if you can get a home line of credit or second mortgage even though you have a payment option ARM.
If we could see into the future with a crystal ball, the comparison would be easy. If interest rates were 15%, an adjustable-rate mortgage (ARM) would be the smart choice. If interest rates were 5%, a balloon mortgage would be the smart choice. Because of how uncertain the future of interest rates is, it's clear that making this choice comes with some risk.
