Pros and Cons of an Interest Only Mortgage
Would you take out an interest-only mortgage? These are mortgages that never reduce the principal balance and, while they fulfill a certain niche, they are not for every buyer. It means you will always owe the same amount of money regardless of how many payments you make because you are only paying the interest.
Interest-only mortgages are loans secured by real estate and often contain an option to make an interest payment. You can pay more but most people do not. People like interest-only mortgages because it's a way to drastically reduce your mortgage payment. News headlines often distort the truth about interest-only mortgages, making them out to be bad or risky loans, which is far from the truth. As with any type of financing instrument, there are pros and cons. Interest-only mortgages are not inherently evil in themselves.
What Is an Interest-Only Mortgage?
Interest-only payments do not contain principal. Many of the interest-only mortgages available today feature an option for interest-only payments. Here is an example:
- $200,000 loan, bearing interest at 6.5%. Amortized payments for a 30-year loan would be $1,254 per month, containing principal and interest.
- An interest-only payment is $1,083.
- The difference between a P&I payment and an interest payment is a savings of $170 per month.
Common Interest-Only Mortgages
The most popular interest-only mortgages do not allow borrowers to make an interest-only payment forever. Generally, that time period is limited to the first five or ten years of the loan. After that period, the loan is amortized for the remainder of its term. This means the payments move up to an amortized amount but the loan balance is not increased. Two popular mortgages are:
- A 30-year loan. The option to make interest-only payments is for the first 60 months. On a $200,000 loan at 6.5%, the borrower has the option to pay $1,083 per month at any time within the first five years. For years 6 through 30, the payment will be $1,264.
- A 40-year loan. The option to make interest-only payments is for the first 120 months. On a $200,000 loan at 6.5%, the borrower has the option for the first ten years to pay an interest-only payment in any given month. For years 11 through 40, the payment will be $1,264.
How to Compute an Interest-Only Payment
It's simple to figure mortgage interest. Take an unpaid loan balance of $200,000 and multiply it by the interest rate. In this case, the rate is 6.5%. That number is $13,000 of interest, which is the annual amount of interest. Divide $13,000 by 12 months, which will equal your monthly interest payment or $1,083.
Who Would Take Out an Interest-Only Mortgage?
Interest-only mortgages are beneficial for first-time home buyers. Many new homeowners struggle during the first year of ownership because they are not accustomed to paying mortgage payments, which are generally higher than rental payments.
An interest-only mortgage does not require that the homeowner pay an interest-only payment. What it does do is give the borrower the OPTION to pay a lower payment during the early years of the loan. If a homeowner faces an unexpected bill -- say, the water heater needs to be replaced -- that could cost the owner $500 or more. By exercising the option that month to pay a lower payment, that option can help to balance the home owner's budget.
Buyers whose income fluctuate because of earning commissions, for example, instead of a flat salary, also benefit from an interest-only mortgage option. These borrowers often pay interest-only payments during slim months and pay extra toward the principal when bonuses or commissions are received.
How Much Do Interest-Only Mortgages Cost?
Because lenders rarely do anything for free, the cost for an interest-only mortgage might be a bit higher than a conventional loan. For example, if a 30-year fixed-rate mortgage is available at the going rate of 6% interest, an interest-only mortgage might cost an extra 1/2 percent or be set at 6.5%.
A lender might also charge a percentage of a point to make the loan. All lender fees vary, so it pays to shop around.
What Are the Risks & Myths Associated With an Interest-Only Mortgage?
The important aspect of an interest-only mortgage is to remember that the loan balance will never increase. Option ARM loans contain a provision for negative amortization. Interest-only mortgages do not.
The risk associated with an interest-only mortgage lies in being forced to sell the property if the property has not appreciated. If a borrower pays only the interest each and every month, at the end of, say, five years, the borrower will owe the original loan balance because it has not been reduced. The loan balance will be the same amount as when the loan was originated.
However, even an amortized payment schedule typically will not pay down enough of a 100% financed loan to cover the costs to sell if the property has not appreciated. A larger down payment at the time of purchase reduces the risk associated with an interest-only mortgage.
If property values fall, however, the equity received in the property at the time of purchase could disappear. But most homeowners, regardless of whether a loan is amortized, face that risk in a falling market.