An interest-only mortgage allows the borrower to pay only the interest rate, for a preset period of time. The term for this kind of monthly payment could range between 5 and 7 years. Now, you may wonder about your payment options at the end of this period. You can:
– Refinance your home;
– Make a larger sum payment;
– Start paying off the loan principal.
Once you start paying the principal, the monthly payments will be considerably higher than those in the interest-only period. If you use the option to pay only the interest, for a long period of time, the amount you owe will remain the same in the principal.
Who Is the Right Candidate for an Interest Only Loan?
Interest-only loans are right just for some consumers. It is of paramount importance that you find out about several types of mortgages before deciding which one suits your needs. Yet, there are several reasons why borrowers may prefer an interest-only mortgage:
- They do not intend to remain in the house for a long period of time and intend to resell in the near future.
- They want a lower payment to start with and have confidence that they will afford larger payments at the end of the interest-only period.
- They want to afford more home.
Interest-Only Loans Advantages
Every type of mortgage has its advantages and disadvantages. The pros of having an interest only mortgage loan are:
- During the term, the borrower makes lower monthly payments.
- The borrower can buy a bigger home later when they qualify for a larger loan amount.
- The borrower can invest the extra money to build net worth.
- There is tax deductibility for the monthly payment during the interest-only period.
Drawbacks of Interest Only Loans
Interest-only mortgage plans have some noteworthy downsides. They include:
- The risk of a rising rate if it is an adjustable rate mortgage.
- Instead of saving or investing the extra money, many people spend it.
- Lots of borrowers lack the determination to make payments towards the principal during the interest-only period. When the time comes for higher payments, they find out they can’t afford them.
- Budget increase may not go according to the initial estimates of the borrowers.
- The value of the home may not increase as fast as expected by the borrower.
Further Risks with Interest-Only Loans
- There is a risk of “payment shock”. This happens because borrowers get used to paying only the interest rate. And the time comes when they have to pay part of the principal added to the interest rate. This increases the monthly payment significantly and causes strain on the budget.
- Some loan packages come with a minimum-payment requirement, which doesn’t even cover the full interest rate. The unpaid interest adds up to the principal. If the borrower ignores this aspect, they can end up with a much higher amount than the original borrowed sum. Moreover, the monthly payments will increase.
- There are options to avoid the “payment shock” that accompanies the end of the interest-only period. Yet, who can anticipate the interest rate in ten years? You may not be able to refinance at that time if the value of the home is lower than the loan balance.
- Interest-only loans could have pre-payment penalties. You could end up with lots of additional fees if you refinance during the repayment penalty period. Find out about such penalties before you sign the loan.
- The amount owed for the mortgage may be higher than the home value. Borrowers often fall in the trap of negative amortization, meaning that even if they manage to sell the house, they would still owe more on the mortgage. The debt, in such cases, would be higher than the amount the homeowner gets from the buyer.
Who is the Ideal Candidate for an Interest-Only Loan?
Interest-only loans could make the right choice for some borrowers, under certain circumstances. Thus, if the following apply, the interest-only payment is the best option:
- The borrower has a modest income at present but has the certainty of income increase in the future.
- The borrower can use the home equity to invest for net worth growth or to make principal payments.
- The borrower has irregular income and would prefer interest-only payments when the income is low and larger payments when the income goes up.
Interest-Only Loan Alternatives
It may prove a challenge to use an interest-only loan into your advantage. It may not be the right choice for you! Try to find out as much as you can about such a loan to see if it suits your needs. Other options ought to be explored if inconveniences are identified for the interest-only mortgage.
- See if you can qualify for a community housing program as they have lower fees on first home purchase and better interest rates. Owning a home could become a lot more affordable with such a program.
- A fixed-rate mortgage could be safer for your future. Shop around and compare features and loan terms to make sure that the mortgage suits the budget.
- Make savings for a larger down payment so that you don’t need to borrow a very large amount. It would be much easier to pay the monthly rates then.
- Start with a cheaper home. You can move to a bigger and more expensive property once you build equity.