Prepayment Penalties

Many people who are having financial difficulties or who are having trouble qualifying for the amount of home they want based on their current income find that they can leverage their purchasing power by applying for an interest-only mortgage.
With an interest-only mortgage a borrower pays only monthly interest charges and makes no payment to reduce the principal of the loan. This arrangement results in a lower monthly mortgage payment but does not allow for equity build-up through the reduction of principal and at the end of the interest-only term of the loan will require the borrower to make substantially higher monthly mortgage payments in order to pay off the full principal in the time remaining on the loan.
One way to lower the amount that will be rolled over into the fully-amortized loan at the end of the interest-only period of the loan would be to make payments on the principal during all or part of the interest-only option period.
This strategy applied either continually or just during periods when extra funds are available would result in a lowering of the monthly payment even more during the interest-only period of the loan and would result in a lower monthly payment after the conversion of the interest-only loan into a fully-amortized loan. It would also result in less interest being paid on the loan over the lifetime of the loan.
Many lenders prefer than you do not prepay your interest-only mortgage. The way they entice you into not making any principal prepayments, at least for a substantial part of the time that the interest-only option is in effect, is to offer you a reduced interest rate if you agree not to make any prepayments on your principal for, say, the first three years of a five year interest-only option, or for the first five years of a ten year interest-only option.
Your decision will depend on your financial situation. If you have a variable income, with periods of high income followed by periods of little or no income, keeping your prepayment option may be a wise choice.
On the other hand, if your income is likely to remain static during the interest-only portion of your loan period, then it may pay you to take a reduction in your interest rate in exchange for not making any prepayments which you probably would not have made anyway.
Remember, interest-only loans are not right for everyone and you need to ask questions and run numbers over a wide range of possible scenarios before you make any final decisions.