A Guide to Interest-Only Mortgages

FT Contributor  | 

Home mortgages are associated with high monthly payments, discouraging many renters from feeling they can afford to purchase their own homes. However, there are different types of home loans that make home buying more affordable. Interest-only loans allow a buyer to pay only the interest on their mortgage for a certain period of time.

Potential homebuyers with tight budgets may be able to afford to purchase their homes with these types of mortgages. While these homebuyers are treated to low monthly mortgage payments, they must be prepared for when the interest-only term expires and they begin paying off the principal loan balance.

Interest-only mortgages are unique so it’s important to explore their characteristics before agreeing to loan terms. Learning more about how these loans work and the buyers who are best suited for interest-only mortgages will help you figure out if this financing option is right for your situation.

What Is an Interest-Only Loan?

With an interest-only loan, the borrower pays only interest for a term. When this term is over, the loan balance begins to amortize, or be included in the monthly payments. The monthly mortgage payment the borrower owes after this interest-only term is over increases. The borrower pays this new monthly payment until the principal amount is paid off.

Since the beginning of the loan term didn’t help to actually chip away at the loan balance, interest-only loans generally have longer terms than traditional loans. Interest-only loan terms are usually 30 to 40 years, so borrowers make a long commitment to paying off their home.

The interest rate a borrower is responsible for paying depends on the terms the lender offers. Lenders use several factors to calculate the interest rate, such as the home’s price and location, the borrower’s credit score, and the loan type. The down payment a borrower provides also comes into play when the lender calculates the interest rate.

How Long Can You Pay Interest-Only Mortgage?

Eventually the borrower’s interest-only loan term is over and they’re responsible for beginning to also contribute payments to the balance of the loan. The interest-only term of the loan varies but is usually between five to 10 years.

Interest-Only Loan Example

An interest-only loan example will help you understand how this type of mortgage works. Say you bought a home for $200,000 and agreed to a 40-year interest-only loan with a 10-year interest only period. Your interest rate is 6.5%, so your monthly payments throughout the interest-only period are $1,083.

When your interest-only term is over, you’re responsible for paying down the principal in addition to this interest for the next 30 years of your loan term. Your monthly payment for the last 30 years of the loan is $1,264.

You’re paying more in interest than you would for a traditional mortgage over the life of the loan. This is because you’re only providing interest to the lender for the first 10 years and not addressing the principal loan amount until the last 30 years of the mortgage term.

Benefits and Risks of Making Interest-Only Payments

Before agreeing to an interest-only loan, it’s important to review the benefits and risks you may encounter with this financing option.

Benefits

If you’re struggling with a tight budget, an interest-only loan makes it easier to afford to buy a home. Your interest-only monthly mortgage payment includes expenses such as taxes and insurance. When you start paying principal, your monthly payment will increase but if you have a long loan term, it shouldn’t be a big jump.

While the lender only requires you to pay interest in the first term, you may decide to begin paying some of the principal if you can afford it. This shortens your loan term and allows you to pay off the loan balance faster. If you have an expensive month due to a home repair or medical bill, you can pay as low as the original interest-only payment to free up the cash you need.

You can deduct your mortgage interest from your taxes. Since you’re only paying interest for the first term, you qualify to deduct your entire mortgage payment from your taxes, as long as you didn’t pay any of the principal.

Risks

With an interest-only loan, you’re subject to a long loan term. It’s rare that your home’s value appreciates throughout this time period to offset the additional payments you made in interest. For example, you bought a house for $200,000. Throughout the life of your 40-year loan, you paid a total of $350,000 for the home. At the end of the loan term, the home appreciated but is only worth $280,000.

During the interest-only period, if you don’t make additional principal payments, you don’t earn any home equity. If you ever need cash, you won’t qualify for a home equity loan until you pay down a significant portion of the principal.

If you opt for an interest-only loan instead of a conventional home loan, you must be prepared for the end of the interest-only term. Once the term is over, your monthly financial responsibility increases. If you don’t have a plan in place to cover this higher monthly payment, you may default on your mortgage.

Best Practices for Managing an Interest-Only Loan

Since your interest-only loan converts from an interest-only term to the rest of the loan that includes paying down the principal, it’s important to manage your finances. With an interest-only loan, it’s best practice to:

  • Pay more than just interest: If you can afford to pay some of the principal during your interest-only term, pay what you can comfortably afford. It’ll help reduce your loan term and pay off the balance faster.
  • Prepare for increased monthly payments: Be sure you’re not living on a tight budget during your interest-only term. Your monthly mortgage payments will increase when this term is over, so make room in your budget for these higher payments to avoid defaulting.
  • Understand your loan payments: Review your loan documents and ask your lender questions about your responsibilities. Be sure you’re not signing up for a predatory mortgage loan and that the terms are favorable for your situation.
  • Calculate your loan’s overall cost: It’s important to understand the monthly payments you’ll be required to pay, as well as the overall cost of the loan to determine how much you invested in the home. Use an interest-only loan calculator to find out how much you’ll pay over the life of the loan and if it’s worth it.

An interest-only loan offers low monthly mortgage payments that may allow you to buy a home, even if you thought you couldn’t afford homeownership. However, reviewing your loan terms and being prepared to begin paying down your principal is important to avoid defaulting on your mortgage.


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