Do Interest Only Loans have Prepayment Penalties – If so, How do they work?

Most “Interest Only” loans do not have prepayment penalties.  However, if the lender is a Federally Chartered Lender, your loan can have a prepayment penalty---even if your state does not normally allow for such penalties.

Prepayment penalties are a way of the lender to discourage the borrower from refinancing the loan so the lender does not have to take any losses.  Loans with a prepayment penalty work against borrowers by preventing them from capturing still lower rates and terms as markets change.  The option will depend on your application profile and the lender you choose but you may be able to save up to 0.25% on the rate just by taking a prepayment penalty for the first 3 years.

Are these Balloon Mortgages?
No.  Most “Interest Only” loans are not balloon type mortgages.  Those that have a longer initial fixed period such as the 3, 5, 7 and 10 year programs will not have the note due and payable at the end of the fixed term.  The mortgage will simply turn into a fully amortized loan thus your balance (after 5 years on a 5 year fixed interest only loan) will be amortized over the remaining 25 years as a normal 25 year “principal and interest” mortgage would except at an adjustable rate.

Can I convert to a fixed rate?
Most “Interest Only” loans do not have fixed rate conversion options.  The only way to  change the rate is to  refinance to a fixed rate mortgage.

What happens to my loan margin when the fixed term ends?
This depends on the final product selected.  Typically, the higher the margin-the lower the index and visa versa, this tends to balance out various loans utilizing different indexes.

What does this mean to you? It means once your initial fixed rate period is over you will be subject to the measured index of your mortgage product plus a pre-defined margin based on the lender's mortgage note.