An interest-only mortgage is one where you only pay the interest for the first several years of the loan, for five or 20 years. Once the period ends, you have to pay both principal and interest. To pay the principal payments during the interest-only period, you can but that’s not a requirement of the loan. Just keep in mind that the amount of time you have for repaying the principal is shorter than your overall loan term.
How does interest-only work?
The interest-only loans are structured as adjustable rate mortgages, the interest-only payments can last up to 10 years. After a certain period of time, start repaying both the principal and interest. This is repaid in either a lump sum or in subsequent payments. The rate of your interest can either increase or decrease throughout the length of your loan, so when your rate adjusts, there will be a change in payment too.
If you take a $200,000 interest-only ARM at 5%, with an interest only period of 10 years, then you have to pay $817 per month for the first 10 years. When this interest-only period ends, your monthly payment amount will rise with inclusion of both principal and interest payments.
Why get an interest-only mortgage
Probably, common people who apply for an interest-only mortgage will not look for owning a home for a long-term rather they might be the frequent movers or are purchasing the home as a short-term investment.
If you’re looking to purchase a second home, then consider an interest-only loan. Some people may buy a second home and turn it into their primary home. If you don’t live permanently in the home yet then making payments towards interest will be good.
An interest-only loan may be suitable for people who are looking to keep their payments low, but it’s quite difficult to get approved and is typically more accessible for people with significant savings, high credit scores and a low debt-to-income ratio.
The pros of an interest-only loan
The monthly payments are lower in the early stage: For the first few years, you’ll pay only the interest so your monthly payments are usually lower compared to some other loans.
May help you afford a pricier home: You can get a large amount because of the lower interest-only payments during the introductory period.
Can be paid off faster than a conventional loan: If you’re making extra payments towards an interest-only loan, then you have to pay the lower principal amount only which generates a lower payment each month. When it comes to a conventional loan, extra payments can reduce the principal, but the monthly payments remain the same.
Possible increase to your cash flow: Lower monthly payments can help you save money on your pocket.
Rates may be lower: This type of mortgage is usually structured as an adjustable-rate loan, which results in lower rates than a fixed mortgage.
The cons of an interest-only loan
You’re not building equity in the home:
To increase the value of your home, equity is very important. With an interest-only loan, you aren’t building equity on your home until you start making payments towards the principal.
Low payments are temporary:
Low monthly payments for a short period of time may be an attractive offer, but they don’t last forever. Once the interest-only period ends, your payments will suddenly increase.
Interest rates can go up:
Interest-only loans come with variable interest rates. If the rates increase, the amount of interest you pay on your mortgage will go high.