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Pros and Cons of an Interest Only Mortgage
By Candice Pardue
When buying a new home, you might be bombarded with financing options that are difficult to understand. The interest only mortgage, for example, can sound very intriguing because of its label "interest only," however, this type of loan only benefits a family or individual if certain conditions apply. You should be aware of the advantages as well as the pitfalls of these types of loans before making a decision.
What is an Interest Only Mortgage?
An interest only mortgage enables you, as a home buyer, to make payments on only interest for a set number of years before paying toward the premium. It's a creative financing method that lowers your payment tremendously during those initial years to free up funds for other things, or lowers the minimum payment to make a home purchase feasible.
The term "interest only" applies to only the first years of your loan, not the entire loan term. For example, during a period of five years, your monthly payment involves only the due interest instead of the usual "interest plus premium" scenario. For the first five years, you'll be able to enjoy very low payments, but then the premium must be amortized over the next 25 years. Your remaining payments will be higher to make up for the five years of interest only mortgage payments.
Length of an Interest Only Mortgage Period
The length of your interest only period is determined by you and your lender and is based on your financial situation. Interest only loans might be 1, 3, 5, 10 or even 15
years. Once the interest only period ends, the principal amount must be amortized over the
remaining period of the loan.
Are the Rates Always Fixed for Interest Only Mortgages?
Interest only mortgages don't always have fixed rates. Some have a fixed rate during the interest only period and are then converted to ARMs after the initial period. This can be risky since the interest rate might rise, causing your payments to go
even higher.
How to Know if an Interest Only Mortgage will Benefit You
There are two categories of people who can benefit the most from interest only mortgages. If you fit into one of these categories, you might benefit from this type of loan:
1. Home Buyer Who Needs a Low Payment
If you're trying to purchase a certain type of home that's too expensive in payments at the moment of purchase, you might benefit from an interest only mortgage. The
initial interest only payments might be just low enough to enable you to get approved for the loan based on your current income/debt ratio. You only
want to use this method if you're expecting your income to increase before your mortgage payments go up.
This can also work if you expect to pay off another debt within the initial interest only period, freeing up that money to make your higher mortgage payments later.
You can also benefit by claiming the mortgage interest on your taxes. Your entire payment will be tax deductible during the interest only period if the amount doesn't exceed the tax limitations for mortgage interest.
2. Investor
If you're a real estate investor who plans to remodel and resell the home before the interest only period has ended, this will work very well. Your should be careful not to pay too much for the home because the entire price of the home will still be due when sold.
If you're a savvy stock market investor who wishes to use the additional saved money each month to earn a return, you might also benefit from an interest only mortgage. This, too, should be carefully thought out in terms of how much you can earn, and if it will be enough to justify the higher payments later. There's a certain amount of risk with any investment.
Potential Pitfalls of Interest Only Mortgages
There are potential pitfalls of interest only mortgages you should be aware of before committing to this type of loan. One primary concern should be your ability to pay the high payments after the interest only period has ended. You should hope for the best, but also be prepared for the worst. If you foresee a raise in income or certain things coming to pass soon that will enable you to make those high payments, you should also plan what you're going to do if those things do not work out. Another potential hazard is if you need to sell the home after just a few years. You won't have any equity built up, and might actually lose money in the process.
Home Value Risks
Another risk to consider is the fact that your home's value could possibly depreciate. Not all real estate appreciates over the years due to various circumstances. Communities can go downhill, properties can be developed on nearby land with structures that take away from the neighborhood's value, natural disasters can occur, etc. There are no absolutes with real estate, so you need to have an alternate plan.
Are Interest Only Mortgages the Same as Balloon Loans?
Interest only mortgages can become balloon loans if the entire principal amount is paid off in one bulk payment at the end of your loan term. During the entire duration of the loan, you'll only pay the interest off, but still owe the principal at the end of the loan, which will be paid off in a lump sum.
Before getting an interest only mortgage, consider both the advantages and disadvantages above. Determine whether you fit into the category of someone who could benefit from an interest only mortgage. Interest only mortgages might be a wise choice when certain conditions apply.