Interest Mortgage Only

Traditional fixed-rate mortgages have payments that are part principal and part interest. If your payment is $1000 per month, $800 of that may be interest and $200 principal. The lender gets their cut (the $800 in interest) while the borrower gets the benefit of creating equity in their home by paying down the outstanding balance (the $200 in principal). An interest-only mortgage allows borrowers to have a lower minimum monthly payment by requiring them to only pay the interest portion of their loan. For some borrowers, this is an option that could make sense, but these interest-only loans are not for everyone.

An interest-only loan generally consists of a traditional loan, such as a 30-year fixed-rate mortgage, that has two parts. The first is the interest-only term, usually 5-10 years, during which the borrower is required to pay only the interest due on the loan. The second part is the remaining 20 years during which the balance of the loan is amortized like a traditional mortgage.

Who would benefit from an interest-only mortgage? Experts say that the ideal candidate for this option would be a corporate executive with a modest salary but occasional large bonus or commission payments. The interest-only option would allow this borrower to make the smaller, interest-only payments during the months that his/her income is relatively low, and then make larger payments that would be applied to the principal in the months that commission or bonus payments are received. Other candidates for these loans would be borrowers who expect their income to grow significantly over the foreseeable future and borrowers in markets where home values are increasing at a steady and significant rate.

What are the potential problems with interest-only mortgages? Because the principal is not being paid down during the interest-only period, lenders view these loans as higher risk loans and, consequently, they generally carry a higher interest rate than traditional mortgages. Secondly, if you don’t pay off the loan or refinance before the end of the interest-only term, your minimum payment will increase significantly once it starts being amortized like a traditional loan. This option also works best with borrowers who have the financial discipline to actually apply that “extra” money like bonuses or commissions to the principal on their mortgage. Even though an interest-only mortgage may make sense mathematically, psychology often gets in the way of executing a good plan. Will you be able to apply that extra money to your mortgage payment and resist the temptation to take a vacation or buy a new car instead? Finally, these loans make the most sense in a market where home values are increasing. How confident are you that this will be the case for you and your home?

Interest-only mortgages are an option worth considering for those who fit the criteria, but they are definitely not for everyone. As with any financial product, do your research and know the details of the product you are considering before signing on the dotted line.