In an interest only mortgage, the borrower covers interest on payments for a specific period of time, paying the cost of borrowing money up front, while the principal remains unchanged. This allows for reduced monthly mortgage payments early in the loan term. An interest only home loan can offer flexibility to buy a more expensive home than a borrower initially qualifies to buy. They can also be a great way to lower payments so you can divert your cash flow toward retirement, college tuition or a rainy day fund.
In traditional mortgages, payments are applied to both interest and principal. Through amortization the balance of the loan decreases over the term of the loan. Interest only mortgages are structured differently: The most common version pushes back the amortization schedule, usually 5 to 10 years, while the borrower pays interest only. The other type lasts the duration of the loan, with an agreement principal that will be settled with one balloon payment at the end of the term.
While initial payments as part of an interest only mortgage are lower, borrowers should be aware that over the life of the loan they are more expensive than traditional mortgages. Interest only loans can also be subject to adjustable interest rates. Negative amortization, a feature where missed interest payments are applied to the principal balance, is also a risk inherent to interest only loans. Keep reading to learn more and explore the circumstances that make the most sense to purse an interest only loan.
Is an interest only mortgage right for you?
Here are five questions to help you determine whether an interest only mortgage is the perfect match:
Are you confident your income will grow in the future, but want to purchase high-value real estate now?
Are you more interested in lower monthly mortgage payments than building home equity?
Are you looking to invest your money in something other than your home?
Are you fine with the prospect of your monthly mortgage payment going up when the interest-only term ends?
Do you own investment homes and rent them out?
If you answered “YES” to any of these questions, an interest only mortgage might be your best bet! A word of consideration—while interest only home loans offer low monthly payments during the initial term of your loan, your monthly payments will rise after this term ends to cover the principal. If you don’t expect your income to increase in the foreseeable future or if you’re unsure you’ll be able to make the larger payments later on, a 15 or 30-year fixed rate mortgage could be a better fit. In addition, it may be more difficult to refinance your mortgage if your home value doesn’t increase during the lifetime of your loan. Those buying a home for the first time may find interest-only mortgages particularly beneficial. For new homeowners, who are unaccustomed to the higher cost of mortgage payments and the other costs of maintaining a home, the first years of home ownership can be particularly challenging. In many cases, you are buying a house you expect to pay off years down the line, when you are more established and may be making more money, thus the initial costs may seem daunting. If a water heater suddenly needs replacing or a roof suddenly needs to be fixed, the option to exercise an interest only mortgage at that time can come in handy, as long as you are able to cover the higher monthly payments later on.If your income is subject to fluctuation either because of freelance work or commissions and bonuses, rather than a typical flat salary, an interest-only mortgage can be similarly beneficial. Pay interest-only payments during leaner months and years with the anticipation of paying more later on. Risks of interest only payments. Making a smaller monthly payment for a period of time, with the anticipation that you’ll have the money to make larger payments down the line, always carries a risk. The total balance of what is owed on your mortgage is not changing, thus if your financial circumstances do change you may find monthly payments more difficult down the line. Additionally, the housing market can be fickle and the property purchased may fail to appreciate in value. Even if the value remains much the same, if the borrower has negative amortization you may wind up owing more on the mortgage than the actual value of the house making it difficult to make a profit on the house when and if they decide to sell. How much is an interest only payment?
When considering an interest only mortgage, do the math to figure out if you're able to handle the amount of the monthly payment. Figuring out the monthly interest only payment on your mortgage is easy. Say that the unpaid loan balance on your property is $400,000 with an interest rate of 7%. Multiply those numbers together for an annual interest of $28,000. Divide that number by 12 months and you can find your monthly interest payment: $2,333. Keep in mind that after the interest-only period, your payments will increase as you begin to pay back the loan principal.