Lower monthly payments which only cover interest may sound attractive right now. But please read the following section thoroughly to make sure you understand the consequences and risks of this type of financing plan.
What is an interest only loan?
Some loans offer you the option to pay only interest for an initial period. This initial period is typically five to 10 years. During this time your required monthly payments would only cover interest and would be lower than they would be if you were paying interest and principal. At any time you can elect to pay more than the required minimum payment, and this money may be applied to your principal. If you only pay the minimum monthly payment for the entire interest-only period, at the end of that period of time the balance of your loan will not have gone down. In other words, you won’t have paid off your loan at all.
This type of loan is best suited for people who need lower payments in the short-term and will be able to cope with higher payments later on. In certain situations, these loans can provide savings and flexibility.
Advantages of an Interest-Only Mortgage
Increased Buying Power
The initial lower monthly payments may allow you to buy a bigger house than what you would be able to afford with a fixed rate mortgage. But you must be able to afford higher payments down the road.
Alternative Investment Opportunities — Rather than paying down the principal of the loan, this type of mortgage allows you use of that money for other types of investments. You may feel that your money can earn a higher rate of return in a different investment vehicle than it would if you simply wait for your house to appreciate in value. Keep in mind that the payments will come due no matter how well your alternative investments succeed.
If you have a fluctuating income, this type of loan would allow you to pay the minimum when your income is low, and pay more when your income is high. Remember that this type of flexibility depends on a high degree of financial responsibility and planning. You would have to discipline yourself to make higher payments whenever you have available funds.
‘Flipping’ or Quick Resale
If your plan is to renovate a home and sell it as quickly as possible, an interest-only mortgage will allow you to make small payments while you own the home, and so could increase your overall return when you sell the home. To make this work, you must understand the condition of the real estate market and be certain that you will be able to sell the home in a reasonable amount of time.
Paying off the Second Mortgage
If you must make payments on a second mortgage or home equity loan with a high-interest rate, it could make sense to postpone principal payments on your mortgage in order to pay down the loan with a higher interest rate. In other words, if an interest-only mortgage allows you to quickly pay off a home equity loan or second mortgage, it could save you money by avoiding the higher interest rate payments.
Penalties for Pre-Payment
Some interest-only loans have penalties for prepayment. This means that if you refinance your loan, or make payments on the principle, during the prepayment penalty period, you will be charged extra fees. Fortunately, the majority of interest-only mortgages let you make payments on the principle without imposing penalties. But don’t forget to check if the loan you’re considering allows this option.
Increased Monthly Payments Later
After the interest-only payment ends, your monthly payments will increase even if interest rates don’t. That’s because you will begin paying back the principal of the loan as well as the interest. Your monthly payments can increase a lot. Perhaps at that time, it would be possible to refinance your mortgage began. But if interest rates have risen by that time, a new loan might not be attractive either. And if your loan balance ends up greater than the value of your home, you won’t be able to refinance.
Lack of Equity
If you don’t pay down the principal for a number of years, and if housing values do not appreciate, you won’t have any equity in your home. In the worst of cases, if your home’s value drops below the level of the loan, you will end up owing more than the house is worth. Such a situation will also make refinancing impossible.
Higher Interest Rates
With an interest-only mortgage, you must expect a slightly higher interest rate. enders impose slightly higher rates because going through a number of years without any return of principle constitutes a higher risk.
An Income Plateau
While you may predict that your income will rise sufficiently to cover increased monthly payments in the future, no one knows what the future will hold. You could suffer an unexpected job loss. Or deteriorating economic conditions could produce stagnant wages. A payment which you can currently afford could become overwhelming when it goes up at the end of the interest-only period.
What’s the Conclusion?
Interest-only mortgages provide flexibility and allow initial lower monthly payments. But interest-only mortgages can have a significant downside. They are only right for certain people in specific circumstances. Before deciding on this option, call us to make sure that an interest-only loan would truly turn out to be advantageous in your circumstances.