Remember what your mother told you -- if something seems to good to be true, it probably is. Interest-only mortgages do have their place in the world of home financing, but only for certain home buyers in very specific financial situations. USA Today reporter Sandra Block warns that “if you don’t understand the risks, you could lose the roof over your head.”
When you borrow money to purchase real estate, called a mortgage, your lender determines your monthly principal and interest payments using a method called amortization. Before you make your monthly or bi-weekly payment, the lender determines the amount of interest accrued during that period based on the loan’s interest rate and the principal balance, or amount you owe on the loan, and applies portions of the payment appropriately. After each payment, the lender deducts the principal you paid from the original loan balance and recalculates the interest for the next payment.
If you opt for a seven-year interest-only mortgage rather than a traditional loan, your lender still amortizes the mortgage over the entire length of the loan, usually 30 years. For the first seven years, you pay only the interest due on the loan. At the end of the interest-only period, the lender recalculates the loan so that you pay off the entire principal balance and accrued interest during the remaining 23 years, usually resulting in significantly higher mortgage payments.
How an Interest-Only Mortgage Can Help
Since a seven-year interest-only mortgage offers lower payments for the first seven years of the loan, you gain additional purchasing power to buy a more expensive home than you can presently afford in anticipation of your earnings increasing before the interest-only period is over. You might also want to consider this type of mortgage if you receive the bulk of your income in annual bonuses or commissions. The lower payments will help you through the leaner times, but you still have the option to pay a lump sum towards the interest when you receive your bonus. If you expect housing prices to remain stable or rise and you plan to move before the interest-only period is over, you might also benefit from this type of mortgage.
What Can Go Wrong
Since an interest-only mortgage does not require you to reduce your original loan balance during the initial period, this type of loan is especially susceptible to the ups and downs of the economy. If the housing market sees a significant downturn, you could find yourself in an “upside-down” loan or mortgage that is “under water“ where you owe more on the mortgage than the home is worth. If prevailing interest rates have risen significantly before the lender recalculates the mortgage, you could find yourself with payments you are unable to afford.
Before you sign on for a seven-year interest-only mortgage, make sure that the benefit outweighs the risks. If your mortgage is for $200,000 at 6.0 percent interest, your monthly payment during the interest-only period is a mere $200 less than it would be with a traditional mortgage. The Wharton School’s Professor of Finance Emeritus Jack Guttentag cautions that if you don’t need an interest-only mortgage to qualify for the house you want to buy, it isn't the best choice.
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