An interesting feature of interest only loans is that your payment is re-calculated each month based on how much money you are borrowing.
The industry term for the re-calculation is “recasting”.
When an extra principal payment is made on an interest only loan, the new loan payment is calculated as:
(Outstanding Loan Size) * (Annual Interest Rate) / (12 months)
Therefore, an additional $500 principal payment against a $200,000 interest only loan at 6.000% will reduce next month’s mortgage by $2.50, or $30 annually.
$30 is six percent of $500.
This is in contrast to an amortizing loan in which your mortgage payment never changes until the loan is satisfied. Any additional payments to principal on these types of loans shave months off the end of a loan.
Recasting is not exclusive to interest only loans, however. Many lenders will allow you to recast an amortizing loan for a small fee ($100-500) but may limit the total number of times you can recast over the life of your loan.
Interest only loans recast once monthly.
Interest only loans require discipline and are not proper for every homeowner (the same way that a 30-year fixed is not appropriate for every homeowner, either). However, within a balanced financial portfolio, they can be a terrific financial planning tool.