Annual Principal Payments on an Interest-Only

2 May 2005

"I realize that I don’t pay principal on an interest-only, but 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% for 30 years, the fully- amortizing payment is $1199.11. This is the amount that, if paid every month, would pay off the loan in 30 years. The interest only payment is $1,000. If you pay $1,000 for 12 months, you must add an extra $2456 to the payment in month 12 to reduce the balance to what it would have been had you paid $1199.11 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 $2456 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 must be larger than the difference between the fully amortizing and the interest-only payments over the year. The monthly difference in payment is $199.11 which, when multiplied by 12, equals $2389. This is the sum of your payment reductions from selecting the interest-only option. It is $67 less than the $2456 payment required at year-end to make up for the absence of monthly principal payments. The $67 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, not so the year-end payment of principal with an IO. It is going to be sooo easy to spend that money differently!

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