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The Interest-Only Mortgage Loan: What Is It, and Why Would You Want One?

Posted by  on Apr 02, 2010
 

Dear Liz,

What is an interest-only mortgage? What does a loan like that offer?

Dennis in Delaware

Dear Dennis,

The ability to make interest-only payments is a feature that can be attached by mortgage lenders to many home loans. The interest-only option can make excellent sense if chosen for the right reasons and with full understanding of the consequences.

Interest-only home loans are like regular mortgages, but for the first 5 or 10 years, the payments cover only the interest owed. Interest-only home loans are a popular way for borrowers to get a lower mortgage payment and perhaps afford more house. By paying less each month toward the mortgage, the homeowner has more cash that can also be used for other investments, such as in stocks, savings, or a small business. Or the money could be used to pay off high-interest consumer debt like credit card balances.

Interest-Only Home Loans as an Investment Strategy

By using the money elsewhere, you are betting that your alternative investments (or savings from paying off debt) will more than offset the cost of not paying down the mortgage balance for the first 5 to 10 years. And after the 5 to 10 years are up, you expect to have the equity for a mortgage refinance or to pay down your mortgage with a lump sum. Many seasoned investors don't see dumping all of their discretionary income into paying down a mortgage loan principal when they can better invest that money elsewhere.

Pros of Interest-Only Home Loans

  • Other investments might generate more cash than would be saved in total interest by paying down your mortgage principal.
  • Those with seasonal, self-employment, or sporadic income can pay less when income is down and opt to pay more when they are flush.
  • Those expecting a substantial income increase (did you just graduate from medical school?) or windfall (do you have a rich old uncle?) can buy more house now and pay more later, when they can more easily afford it.

Cons of Interest-Only Home Loans

  • If you don't invest or save the extra money, you can find yourself in trouble when the payment increases. This type of mortgage loan is not a plan for buying big-screen televisions and taking exotic trips!
  • If you aren't disciplined enough to make extra principal payments when you don't have to, you could find yourself unable to make payments later.
  • You may overestimate your future income.
  • Your investments may tank. Always have a Plan B if you choose one of these loans with the intention of investing money elsewhere to beat the interest rate.

The consequence of taking an interest-only home loan without understanding it is this: After the first 5 or 10 years, your loan's balance has not gone down. And you now have only 25 or 20 years to pay it off. So your payment has to increase substantially. For example, on a $400,000 loan at 5.5%, your interest-only payment in the early years is $1,833, a $438 savings over the regular payment of $2,271. But after 10 years, your payment jumps $919 to $2,752. At that time, you have to be prepared to make the higher payment, pay down the principal in a lump sum, or refinance your mortgage.

Liz



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