Interested in Interest-Only? Here’s What You Should Know

It used to be the case that you had only one choice when it came to paying off your mortgage - the conventional principal and interest plan.  Every month your payment would consist partially of interest (what you owe the lender for using his or her money) and partially of the principal (the actual amount you borrowed), and you would have the loan paid off, little by little, after a certain number of years.

But in 2001, a new type of mortgage was introduced - the interest-only mortgage - in which borrowers are required to make payments only on interest for an introductory period of usually three, five, or ten years.  When this period is over, the principal is then paid down, either in one lump sum or in monthly payments.  This means that, compared to the traditional mortgage, the initial monthly payments are much lower, but the future principal and interest payments will be much higher.

Why It’s Good
An interest-only mortgage is also good for people who either have limited funds now but are expecting to earn more in the near future, or whose income is mostly in the form of infrequent commissions or bonuses.  In both of these cases, the borrowers will not be under pressure to make initial monthly payments that are beyond their means, but once they start earning more or receive those bonuses, they will be able to pay off their principal as well. Therefore, with an interest-only mortgage, you have the ability to buy a house that you normally would not be able to afford.

Borrowers who apply for an interest-only mortgage plan often do it because they are planning on taking the money that they would normally pay for the monthly principal payments and putting it in some type of savings account.  If this is your intention, then make sure you have a strategy for investing the savings and that you will stick to this plan and continue to put your money away wisely.

Why It’s Not So Good
One disadvantage of an interest-only mortgage has to do with the equity in your home.  Since equity is the appraised market value of your home less any outstanding mortgages, then during the period of interest-only payments, you have zero equity to tap into.  This means that if for any reason you need a large amount of money during this time, a home equity loan or line of credit  may not be an option, and you would have to resort to using other alternatives like credit cards or your savings.  Also, if, during this time, your house loses value, then when it comes time to pay down the principal, you will be paying more than the house is actually worth.

Also, it happens that even though borrowers have the intention of saving the difference between their interest-only mortgage and what they would be paying with a traditional mortgage, they are not always able to accomplish it for one reason or the other.  Then, when it comes time to start making payments on the principal, they struggle because they were not able to save the money.  Therefore, you have to be very careful before going into an interest-only mortgage, and make sure that you have a savings strategy in order to come out ahead.

Don’t Rush Into a Decision
Make sure that when you are getting ready to apply for a mortgage that you carefully consider your situation and know how much you can afford each month, both now and in the future.  You should not just hear the words “lower monthly payment” and jump into an interest-only mortgage without examining its details and those of the traditional mortgage.  You have to be sure that you know what you can afford and which type of payments would fit better into your lifestyle, so that you can choose the mortgage that is right for you.  It is also wise to check with a financial advisor so that you make the best decision for your unique situation.

Source: Informa Research Services