An interest-only mortgage is a type of loan in which the borrower is required to only pay the interest on the principal for a predetermined amount of time. When the term of the interest-only mortgage comes to an end, the borrower can either renew the interest-only mortgage or pay off the loan through conventional means, such as a regular mortgage. Conventional mortgage loans require you to pay interest and part of the principal each month, which makes interest-only mortgages a more attractive choice for those who can’t afford a large mortgage payment for the time being.
Popular interest-only mortgage loans don’t allow the borrower to make interest-only payments for a long time and are usually limited to a three to ten years period of interest-only payments, after which the borrower starts making payments towards the principal as well, which will increase his or her monthly payments.
Advantages and Disadvantages of an Interest-Only Mortgage
Like most mortgage loans, interest-only mortgages have their advantages and disadvantages, which means that only home buyers with a certain financial situation will benefit from this type of mortgage, while others will probably benefit from a more conventional type of loan. The most important advantages and disadvantages of an interest-only mortgage loan are:
- Low monthly payments in the beginning. While conventional mortgage loans require each monthly payment to go towards paying both the interest and the principal, interest-only mortgages allow the borrower to make only interest payments for the initial period of three to ten years. This will result in much lower monthly payments for the duration of the initial period, which makes this type of mortgage loan more attractive for first time buyers and people or families who are expecting an increase in their income within the next few years. With this type of loan, you are able to buy a home even if you don’t have a large income at the time. However, once the initial period is over, you must be able to afford larger mortgage payments as you have to start paying off the principal as well.
- High monthly payments later. When the interest-only payment period ends, the amount that you will have to pay on your mortgage monthly may increase significantly because you will start making payments towards the loan principal as well. Home buyers who aren’t prepared will face the risk of not being able to afford to pay their mortgage anymore. The duration of the interest-only period has a large impact on how much your monthly payments will increase. The longer the initial period, the higher your mortgage payments will be once the second repayment period begins.
- You can qualify for a larger mortgage loan. When applying for a mortgage loan, the amount that you can borrow is closely related to your income, and how much the lender determines that you can afford to pay monthly. Because monthly payments are lower on an interest-only mortgage loan than they are on a conventional loan, you will be able to borrow more.
- You will have to deal with an adjustable interest rate later. Interest-only mortgage loans start out with a fixed interest rate, but the rate will become adjustable later on when the second period starts or even earlier. If the interest rate decreases, you’re in luck because your monthly payment will decrease as well, but if interest rates go up, your mortgage payment will increase, too.
Interest-only mortgages are great for first time home buyers. Most of the time, new home owners, being unaccustomed to having a monthly mortgage payment, will struggle with their budget. Interest-only mortgages have lower monthly payments for the first few years, giving first time home owners the chance to get used to making mortgage payments. Whether you are a first time home buyer or not, you should carefully weigh in on the disadvantages of this type of mortgage. The payments may be smaller in the beginning but, if you don’t plan accordingly, you can run into some serious trouble when the second repayment period comes along and your mortgage payment increases.