Interest Only Mortgage
An “interest-only” mortgage is like a line of credit. You can pay only the interest on the mortgage. This can greatly reduce your payments in time of financial stress. However, it also means that the debt will never be paid off.
With an interest only mortgage, you pay only interest for the first five, 10, even 15 years of the loan. This can lower your monthly payment by quite a lot. And that seems to have increased the popularity of interest only mortgages in the past few years.
The interest only mortgage is an interesting mortgage type. All you pay over the life of the mortgage is the interest on the balance. However, there are options once this interest only period ends. You either begin to pay interest and principal at a faster rate than if you’d done that from the beginning, or you can choose the balloon mortgage approach, which means the total loan principal becomes due at the end of your term.
When do interest only mortgages become more popular? Typically, as interest rates rise and the cost of housing increases, more people will look at this type of mortgage. Why? At issue for some consumers is the size of their mortgage payment and making that payment lower. At the same interest rate, an interest only payment is less than a payment of both interest and principal. A lower payment can mean that you will have a higher budget for home shopping. And that makes a big difference for some home buyers.
Many interest only mortgages have an interest only period (5 to 15 years) and then you begin to pay both interest and principal. If your interest only mortgage has a term of 30 years, after your initial interest free term, you would begin to pay interest and principal. You would begin to pay principal as well as interest in order to pay-off the balance by the end of 30 years. This actually means that your payments will be considerably higher than they would have been if you’d paid off principal all along.
Other interest only mortgages are like balloon mortgages. However, most balloon mortgages would ensure that you are paying down the original principal over time. When you pay your final balloon payment, it would be less than the original loan amount because of your payments of both interest and principal. With an interest only balloon mortgage, your final payment should be exactly equal to your original loan amount. All you’ve paid is interest; all the principal of the loan remains.
When would you consider this kind of loan? The circumstances to consider this kind of loan would be unique. Usually, a family with a single wage earner should not be considering this type of mortgage. Your exposure to financial risk would be too high. However, investors might be interested. The advantage with an investment property, that you expect to go up in value, is that the interest you pay is tax deductible. Therefore, you can deduct the interest paid from your taxes, while you own the property. At the end of the period of the loan, you could then sell your property (hopefully at a profit) and take the returns to pay out the mortgage.
However, this is a gamble. There’s no guarantee that the property appreciates in value. And there’s no guarantee that you can sell it when you decide to. If you can’t sell the property, you would have to refinance (unless you have made enough from the property to pay out the balance of your mortgage) and refinancing could cause you some challenges.
The other advantage to this kind of mortgage is that you can save or invest the money that you would have paid in principal on the loan. Again, this situation will usually favor investors of one kind or another.
Interest-only loans come with many of the options of other types of mortgages. With some, you can lock in a fixed interest rate for the full term, while others resemble adjustable rate mortgages (ARM), which carry a fixed rate for a certain number of years and then adjust every six months to a year.
What kind of savings are you looking at on your monthly mortgage payment? They can be significant. Let’s look at an example: You borrow $200,000 using an interest only loan with a 4.75 percent rate and no principal payments due for five years. Your monthly payment will be just $791, or about $250 a month less than if you went with a regular 5-year ARM with the same interest rate.
This can really work for you, if your property appreciates in value. Of course, there’s never a guarantee that prices will go up. And if you don’t sell your property as planned, your monthly payment jumps drastically after your interest only period. You’ll have to be prepared for that.
Interest-only loans can also make sense for people whose income is sporadic, either because they are paid on commission or because they receive a significant portion of their income in annual bonuses. In this case, you have the option of only paying interest some months, but can pay above and beyond the amount due when they get their bonus checks. There is typically no prepayment penalty on interest only loans. This gives you flexibility in applying extra money to your mortgage when you have it, and yet keep monthly payments low.