The Principal Facts of an Interest-Only Mortgage
You are buying the house of your dreams with an
interest-only mortgage. You'll get a low mortgage payment,
and you'll maximize your tax deduction, all on your current income!
Everything seems to be going good. But have you really understood
the concept of interest-only mortgage and how it functions.
So What Is An Interest-Only Mortgage?
Well it may break your bubble but there is no
such thing as an interest-only mortgage - because
eventually you'll have to pay the loan principal as well. In other
words, with an interest-only mortgage loan, you pay only the
interest on the mortgage in monthly payments for a fixed term. After
the end of that term, usually five to seven years, you pay the
balance in a lump sum, or start paying off the principal. Net Net!
What you're really getting is an interest-only payment method which
can be combined with any type of traditional mortgage.
For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
An Interest only mortgage can be an excellent
choice for some borrowers, who have a valid use for a lower initial
required payment. For most homeowners,
paying down mortgage debt is
the most effective way to build wealth. Nonetheless, some may build
wealth more rapidly by investing excess cash flow rather than paying
down their mortgage. Of course for this to hold true, their return
on investment must exceed the mortgage interest rate.
The interest only product was originally designed
for individuals whose income is cyclical. Borrowers with fluctuating
incomes may value the flexibility the IO mortgage gives them. When
their finances are tight, they can make the IO payment, and when
they are flush they can make a substantial payment to principal.
Financial advisers don't recommend interest-only
residential mortgage to regular wage earners who take out moderate-size
loans and don't have a strategy for investing the savings.
An interest-only mortgage might be a good fit
someone whose income is mostly in the form of
infrequent commissions or bonuses;
someone who expects to earn a lot more in a
someone who truly will invest the savings on
the difference between an interest-only mortgage and an
amortizing mortgage, and who is confident that the investments
will make money.
Again, an interest only mortgage is not the right
choice for everyone, but it can be a very effective choice for some
The Deception You should Watch Out For
By remembering one critical fact the borrowers
can save themselves against most deceptions. If two mortgages are
identical except that only one has an interest-only option, lenders
view that one as riskier. The reason is that, after any period has
elapsed, the loan with the IO option will have a larger balance.
An interest-only loan carries a lower interest
rate. Lenders usually charge a higher rate for an identical
loan with an interest-only option. Most interest-only loans are
adjustable rate mortgages (ARMs), and ARMs have lower rates than
fixed-rate mortgages (FRMs). ARMs with the IO option have lower
rates than FRMs because they are ARMs, not because they are IO.
An interest-only loan allows the borrower to
avoid paying for mortgage insurance. Any IO loans with down payments
less than 20% that don’t carry mortgage insurance from a mortgage
insurance company are being insured by the lender. The borrower is
paying the premium in the interest rate rather than as an insurance
Pitfalls of Interest-Only Mortgages - Risks a
borrower should take into consideration
Interest-only payment options began to be offered
to the masses not as a way to leverage their money, but rather as a
way to borrow more money while not increasing the monthly payment.
In turn they are using this method to be the high bidder, or to buy
a somewhat larger home. Borrowers employing this method aren't
"cash-flow" or "income-leveraging" borrowers. What they're doing is
buying more debt.
One always has to remember that with increased
leverage comes increased risk. And if you are a sophisticated
investor, you should take into that as a borrowers who "debt
leverage" into a more expensive home, with a larger mortgage, you
are expecting that your income and the home both will appreciate.
That may not be a big gamble when homes are appreciating, but it
could certainly play differently in a down real estate market.
There is a danger in not reducing the balance. If
prices should fail to increase during the interest-only period, and
if you should find a need to sell the home, you could potentially be
on the hook for thousands of dollars in sales costs which would need
to be paid out of whatever equity (in the form of the down payment)
you started out with.
Lets look at the more extreme side, prices
actually decline during the mortgage holding period. If you finds
yourselves in that situation, coupled with a low down payment, you
could easily going "underwater" -- a descriptive term that means you
are selling the property for less than the remaining balance of the
Not only is house selling for less, the borrowers
– that is you – would be required to somehow coming up with rest of
the money to fulfill the mortgage balance as well as any sales
charges (commissions, inspections, etc).
Interest Rate Risk
Unfortunately, most of the interest-only loans
being made today feature only short fixed interest periods, if any;
some features adjustable rates which can change each month. Thought
the rates are low today, these low rates will inevitably rise.
The Final Analysis
Interest-only payments do have a place in the
world, at least with the practical users. There are borrowers who
can utilize a mortgage with interest-only payments to their fullest.
However, it would require careful financial planning on behalf of
the borrower to avoid going underwater.
Don’t rule out interest-only mortgages. Consider
its pro and cons to your particular situation and the lender you
would be working with. On the hind side also remember to question
yourself that interest-only payments may be working for friends or
family but does it work for you?
About the Author
Tanu Javeri, a stay-at-home mother, is a freelance writer with many
years of experience. She has written articles addressing a range of
subjects from finance to international travel to beauty & health
care. She was formerly a business journalist and a Senior Research
Executive at AC Nielsen. She has gained knowledge on international
markets by the exposure she got from residing in India, Africa and
USA. She is a knowledgeable writer in mortgages,
home equity lines of
credit, private mortgages,
and is a contributor to