When most people think of a mortgage, they think first about a conventional fixed rate 30-year mortgage, which has a monthly payment that stays the same for 30 years. Each monthly payment is divided so that part of the payment is applied to the interest and part of the payment is applied to the principal of the loan.
By contrast, an interest only mortgage is exactly what it sounds like – a mortgage that requires you to pay only the interest on the money borrowed – at least for a while, usually the first five to ten years of the mortgage.
Pros of an Interest Only Mortgage
The primary advantage of an interest only mortgage is the lower monthly payment. Because you are only paying the interest on the loan, and making no payment toward the principal, your monthly payment is lower than what it would be with a conventional mortgage – often by a significant amount. It is important to note, however, that when the interest-only period expires, the monthly payment on the mortgage goes up to an amount that is higher than it would be with a conventional mortgage because the principal needs to be paid off in less time.
An interest-only mortgage can be useful for someone who expects their income to increase in the future, or who wants to spend or invest their money someplace other than a mortgage. An interest only mortgage may also be attractive to someone who plans to sell their home in a short period of time – they wouldn’t be able to build much equity in just a few years, so it may make sense to pay just the interest, so long as they are confident that the value of the home will increase or at least remain level.
If you are experiencing a temporary financial setback and need lower payments for a few years, refinancing with an interest only mortgage may be a viable option. But you would need to be sure that you will be able to refinance again or afford the higher monthly payments when the interest-only period expires.
Cons of an Interest Only Mortgage
Not surprisingly, the biggest disadvantage of an interest only loan is the higher monthly payment after the interest-only period ends. Because you are paying off the same amount of principal in a shorter amount of time, the monthly payment amount becomes larger than it would be for a conventional fixed-rate mortgage for the same loan amount and total length of the mortgage. And, because you are borrowing the entire loan amount for a longer period of time, you end up paying more in interest on an interest only loan than you do on a conventional loan.
Moreover, if the value of the property declines during the interest-only period, you can find yourself “upside down” on the mortgage – in other words, you will owe more to the bank than the property is now worth. Additionally, interest only mortgages frequently require a higher down payment and higher credit score.
Deciding if an Interest Only Mortgage is Right for You
An interest only mortgage might be a good fit for you if one of the situations below applies:
– You can’t afford the monthly payment on a conventional mortgage right now, but will be able to afford the higher monthly payment of an interest only mortgage when the interest-only period expires.
– You plan to sell your new home within five to ten years and are confident that property values will not decline.
– You will be able to refinance your home before the interest-only period expires and be able to afford the new monthly payment.
– You will invest the money you would otherwise pay toward the principal of a conventional mortgage, and earn more on the investment than the extra interest you will pay with an interest only mortgage.