If you’re shopping for a mortgage, you need to know what all of your options are, including the interest-only mortgage. An interest-only mortgage is exactly what it sounds like – the borrower pays only the interest for a set period of time. After the interest-only period ends, the borrower can choose to renew the interest-only mortgage or convert the loan to a traditional (i.e., amortized) mortgage and pay off a portion of the principal as well as the interest each month.
Advantage of an interest-only mortgage
The biggest advantage is that the payments tend to be lower than they would be with a traditional mortgage, since you aren’t paying any principal. The interest rate also tends to be lower, because most interest-only mortgages are structured as adjustable-rate mortgages, and have rates that increase the longer you have the mortgage. Because of the lower payments at the beginning of the mortgage, interest-only loans can be attractive to home buyers who expect their income to increase by the time the interest-only period ends.
Interest-only mortgages also have several disadvantages. The greatest disadvantage is that you will eventually have to pay back the principal, and at that time, your monthly payment will likely increase significantly. Additionally, you don’t build any equity while you’re only paying off the interest, unless the property increases in value. Along similar lines, you could actually end up “upside down” on the mortgage if the value of the property decreases during the interest-only period, meaning the house is worth less than the amount of money you borrowed to buy it. Finally, some interest-only mortgages require a balloon payment at the end, which is a large lump-sum amount.
Another consideration when it comes to interest-only loans is that they can be difficult to obtain. Following the housing crash several years ago, interest-only mortgages were considered dangerous and irresponsible, because many borrowers took out interest-only loans prior to the crash and were unable to afford them after a while. Consequently, interest-only mortgages are now generally only available to borrowers who have large down payments, low debt-to-income ratios, a high credit score, and can qualify for the mortgage based on the higher, later monthly payment.
Interest-only mortgages are most appropriate for borrowers who don’t intend to stay in the property for more than five to ten years (which is the typical length of the adjustable-rate interest-only period of an interest-only mortgage), and/or have a rising income that will allow them to comfortably make the larger monthly payment required in the future. Alternatively, interest-only mortgages may be attractive to someone who receives a substantial bonus-type payment once or twice a year and can use that to regularly pay off principal on the mortgage while maintaining a minimum interest-only monthly payment. Interest-only mortgages are also used by wealthy borrowers who prefer to invest their money in vehicles other than the mortgaged property.
Most first-time home buyers will find that although the lower initial monthly payment of an interest-only mortgage seems desirable, other factors such as the large down payment requirement and larger future payments make it unsuitable. However, if you only plan to stay in your new home for a few years and are confident the value of the property won’t decrease, an interest-only mortgage might be a good fit.