Do remember the interest-only mortgage? Like a lot of mortgage programs, it disappeared during the financial meltdown. But it’s starting to make its way back, and that’s probably a good thing. Interest-only mortgages weren’t a type of subprime mortgage, and they were generally restricted to stronger borrowers. They’re not for all borrowers, but they have a place on the menu of available mortgage options.
How Interest-Only Mortgages Work
Interest-only mortgages are set up as 30-year loans. The interest-only period runs for the first few years of the loan, generally up to a maximum of 10 years. During that time, you’re paying only interest on your mortgage, as the name implies.
A typical interest-only mortgage may include a five-year interest-only term. The rate will be fixed during that time. The advantage is that it will give you a lower monthly payment during the first few years of the loan.
After the initial interest-only period, your interest rate will adjust. It will then revert to an adjustable-rate mortgage, and will adjust based on the adjustment period, which can be anywhere from annually to every five years.
At the same time that the interest rate adjusts, your loan will also begin amortizing the principal balance. If the loan included an interest-only period of five years, it would amortize over the remaining 25 years.
The Advantages of Interest-Only Mortgages
Interest-only mortgages offer some attractive advantages over traditional amortizing loans, including:
Lower monthly payments. As an example, if you were to take a $200,000 mortgage for 30 years at a fixed rate of 4% on a traditional mortgage, your monthly payment would be approximately $955. But if the same loan is interest-only – also at 4% – your monthly payment will fall to $667. That will save you $288 per month.
You can qualify for a larger mortgage. The lower monthly payment means that you’ll be able to qualify for a larger mortgage. If you are qualified for a $200,000 loan based on a traditional self-amortizing loan, you may qualify for a loan of $286,000 using an interest-only mortgage.
Early principal payments can lower your monthly payment. You can lower the monthly payment by making early principal payments. For example, if your mortgage is $200,000, and you pay $10,000 for principal, the interest payments will be calculated based on the remaining balance of $190,000. If you make a partial prepayment on a traditional amortizing mortgage, your payment will never go down until the loan is paid in full.
Interest-Only Mortgages Have Risks Too!
If you are considering an interest-only mortgage, you should also be aware of some of the risks.
No equity build-up. Since you are making only interest payments on your mortgage, you will owe the same amount of money at the end of the interest-only term as you did when you first took the loan.
If property values decline… Since your loan balance is not being paid down, the loss of equity will be greater with an interest-only loan than it will be with a fully amortizing loan.
You have to be well qualified. Since interest-only mortgages are considered to be higher risk loans, underwriting standards are also higher. You will have to have a better credit score and lower debt-to-income ratios than you will for a fully amortizing mortgage.
They require a larger down payment. You won’t be able to go with a minimum down payment, but likely 20% or more.
Watch out for that first payment adjustment! Since the initial payment adjustment will include both an increase in the rate as well as the beginning of principal amortization, your new monthly payment will be much higher than it is during the interest-only payment phase.
When Interest-Only Mortgages Make Sense
Interest-only mortgages are not for everyone, but they can work well for certain types of borrowers.
If you are in the early stages of a career in which your earnings can be expected to rise substantially within the next few years, an interest-only loan can work for you. By the time the loan adjusts, you will have the higher income needed to make the payment comfortably.
The loan can also work well if you are a strong saver. That indicates that you are used to living on less money than you earn, but it also will enable you to accumulate money to make periodic principal payments that can reduce the loan balance, and the future payment.
And certainly, an interest-only mortgage can work if you expect to sell the home before the initial adjustment takes place with the loan.
When Interest-Only Mortgages Should be Ruled Out
If you are uncomfortable with the risks listed earlier, you should certainly avoid applying for an interest-only mortgage. They are also not for borrowers who can barely afford the house payment. After all, the payment will rise at the end of the interest-only period, and that will make the monthly payment that much more difficult to handle.
You should also avoid interest-only mortgages if you plan to stay in your house forever. It’s mostly a short-term mortgage product, designed for buyers who can reasonably anticipate either selling the home after a few years or experience a significant increase in income before the payment adjustment.
But if you are well-qualified, and only in need of relatively short-term mortgage financing, the interest-only mortgage is a definite option to consider.