The borrower only pays the interest on the mortgage through monthly payments for a term that is fixed on an interest-only mortgage loan. The term is usually between 5 and 7 years. After the term is over, many refinance their homes, make a lump sum payment, or they begin paying off the principal of the loan. However, when paying the principal, payments significantly increase.
If the borrower decides to use the interest-only option each month during the interest-only period, the payment will not include payments toward the principal. The loan balance will actually remain unchanged unless the borrower pays extra.
Who Should Consider an Interest Only Loan?
The borrower may consider an interest only mortgage if they:
- Desire to afford more home now.
- Know that the home will need to be sold within a short time period.
- Want the initial payment to be lower and they have the confidence that they can deal with a large payment increase in the future.
- Are fairly certain they can get a significantly higher rate of return investing the moey elsewhere.
Advantages of Interest Only Loans
There are pros and cons with each different type of mortgage. The advantages of having an interest only mortgage loan are:
- Monthly payments are low during the term.
- The borrower can purchase a larger home later by qualifying for a larger loan amount.
- Placing extra money into investments to build net worth.
- During the interest-only period, the whole amount of the monthly payment qualifies as tax-deductible.
Disadvantages of Interest Only Loans
There are some drawbacks to interest-only mortgage plans. These disadvantages are:
- Rising mortgage rates increases risk if it’s an ARM.
- Many people spend extra money instead of investing it.
- Many cannot afford principal payments when the time arrives and many are not disciplined enough to pay extra toward the principal.
- Income may not grow as quickly as planned.
- The home may not appreciate as fast as the borrower would like.
Other Risks Associated with Interest Only Loans
- It is a risk when focusing only on the ability to make the interest only payments. The reason is because the borrower will eventually have to pay interest and principal every month. When this occurs, the payment could increase significantly, leading to what is called “payment shock.”
- If the borrower has the payment-option ARM and they only make the minimum payments that do not include the amount of interest due, the unpaid interest is tacked onto the principal. The borrower can end up owning more than what was originally borrowed. If the loan balance grows to the limit of the contract, monthly payments will go up.
- Borrowers may be able to avoid the “payment shock” that is associated with the end of interest only mortgages. However, it is difficult to predict what interest rates will be in ten years, so if the loan balance is higher than the value of the home, refinancing may not be possible.
- Some mortgages, which includes interest only mortgages have penalties when a borrower prepays. If the loan is refinanced during the repayment penalty period, the borrower may end up owing additional fees. It is important to check with the lender to see if such a penalty may apply.
- The home may not be worth as much as what is owed on the mortgage or it will depreciate quickly if housing prices fall. Even if the prices remain the same, if the borrower has negative amortization they will owe more on the mortgage than what they could get from selling the home. They may find it difficult to refinance and if deciding to sell, may owe the lender more than what would be received from a buyer.
Am I A Good Candidate for an Interest Only Loan?
Although many risks exist, interest only mortgage payments may be the right one for the borrower if the following apply:
- The current income is rather modest and is certain that income will increase in the future.
- The equity in the home is sizeable and the borrower will use the money to go toward other investments or principal payments.
- Income is irregular and the borrower wants the flexibility of making interest only minimum payments during times in which income is low, and makes larger payments during periods in which income is higher.
Alternatives to Interest Only Loans
Not everyone can make an interest only loan work. It is important that the borrower do research to see if such a loan is right for their particular situation. If the borrower finds that the interest only mortgage is not right, then there are other options available. If the borrower is not sure that an interest only mortgage is right, there are other alternatives to consider:
- The borrower should find out if they qualify for community housing that offers low interest rates or reduced fees for homebuyers making their first purchase. This makes owning a home more affordable.
- It is important to shop around for features and terms that fit the budget, so it may be the right decision to consider a fixed-rate mortgage.
- It is important to take time to save money for a bigger down payment, which reduces the amount that needs to be borrowed, which makes payments more affordable.
- The borrower should look for a cheaper home. Once equity is built, the borrower can buy a bigger and more expensive home.