Is An Interest Only Mortgage Right For You?

Interest Only Mortgage Loans: Who Benefits?

Interest only loans result in lower monthly payments in the early years of financing. And higher payments down the road. An interest only mortgage can be right for some homebuyers. or it can be very, very wrong.

Before deciding to get one (or not get one), learn about the pros and cons of interest only loans.

What Is An Interest Only Mortgage?

For homeowners in search of an even lower monthly payment than today’s low rates can offer, an interest only mortgage may be a great alternative. With an interest only mortgage, the homeowner doesn’t make principle payments.

Not making principle payments translates to a lower monthly mortgage expense.

Typically, the interest only period lasts five to ten years. Eventually, you do have to repay the loan, and your payment will have to include principal as well as interest. Alternatively, your loan could require a balloon payment.

As an example, on a 30-year loan of $250,000 at 5 percent, the homeowner may make an interest-only payment of $1,042 for the first five years. Then, for years six through thirty, the principle and interest payment would be amortized over the remaining 25 years.

That results in a principal and interest payment of $1,320 each month. If you just took a standard 30-year fixed mortgage, the payment would be $1,194 for the entire life of the loan.

Homeowners can opt to pay more than just the interest if they choose to do so.

Benefits Of Interest Only Loans

The biggest perk for having an interest only mortgage is the lower monthly payment during the first years of your loan. A lower mortgage payment makes it easier to manage your monthly mortgage obligation.

Lower payments mean you are freeing up money each month. You can choose to apply the savings to another high-yielding investment for retirement, college tuition or perhaps a rainy day fund.
Interest only mortgages can also be ideal for homeowners who have irregular income.

For example, if you’re self-employed, or rely on bonuses or commissions, an interest only loan could help keep your monthly expenses low in your down months. You can always then apply larger chunks towards the principle when you have those higher income months.

Investment property homeowners may also opt for an interest only mortgage.
As their renter pays the going market rental rates, and the home continues to appreciate, the homeowner may reap the rewards of extra cash flow generated thanks to their interest only loan.

Interest Only Mortgage Myths

Interest only loans don’t come without risk. However, there are some myths associated with I/O mortgages.

Some people to see interest only loans as one of the culprits responsible for the housing crash. There was even a time when federal regulators referred to them as “toxic.” One reason many folks were, and perhaps still are, opposed to interest only home loans is they are commonly confused with the once infamous “Pay Option ARM”.

Option ARM mortgage loans were popular pre-housing crisis. A payment option ARM is an adjustable rate mortgage containing four different payment options. One of the payment options associated with option ARMs was, you guessed it, interest only payments.

However, what got many homeowners in trouble was a different payment feature. This option allowed you to make a payment (based on a one percent interest rate) that did not even cover the interest (because the actual rate was much higher than one percent).

The loan balance increased every month they chose this option. In many cases to the point that the loan balance exceeded the property value, making refinancing impossible.

Being upside down in equity, or “underwater,” combined with a significant payment increase, often resulted in the inability to cover the monthly payments due. Payment option ARMs did cause many foreclosures.

The Cons Of Interest Only Mortgages

By paying just interest on your mortgage, your loan balance will never go down. This means you won’t be building any equity in your home.

It can be harder to qualify for an interest-only mortgage, because often, lenders qualify you with the higher payment required once the interest-only period ends. You’ll likely need better credit and a higher down payment than someone using a fully-amortizing mortgage.

Of course, you can always make extra principle payments to add equity.

The interest only period will eventually come to an end. When that period ends, your payment will go up.

Not only will your payment increase, the amortization is based on the years left. In other words, if your loan has a 30-year term and the first 10 years are interest only, that means your new payment will be calculated based on a 20-year term.

Fortunately, if you aren’t comfortable with your new payment, you can opt to refinance out of your interest only mortgage.

What Are Today’s Mortgage Rates?

For a while, interest only loans largely went away. Thanks to a renewed interest and an evolving mortgage landscape, interest only loans are making a comeback.

Do your research and speak to a lender about the pros and cons of interest only loans.
Interest only mortgages can offer great benefits that traditional mortgage loans cannot.