Although buying now what you can’t afford until later may be tempting, think twice. Interest-only mortgages allow you to defer large payments that include principal and interest for a specific period of time. These loans, particularly if the interest rate is adjustable rather than fixed, come with many financial risks, prompting Bloomberg Businessweek to declare them “nightmare mortgages.”
With a traditional mortgage, repayment of the loan begins as soon as you start to make payments. The mortgage lender applies a portion of each payment toward the principal balance and the remainder toward interest on the loan. After each payment, the lender uses a method called amortization to recalculate the loan and determine the amount of interest accrued going forward based on the new loan balance. Although your payments do not change unless you have an adjustable-rate mortgage, the amount of each payment applied toward principal grows over time.
Lenders amortize interest-only mortgages much like traditional mortgages, except that for an initial period of three, five or seven years, you pay only the interest accrued on your mortgage. Because the lender does not ask for any repayment of principal during this period, your monthly payments are less than a traditional mortgage with principal and interest payments.
Assume you took out a $400,000 mortgage over 30 years at 6.5 percent interest, and the lender set up payments of $2,528.27 for a traditional mortgage or $2,166.67 for an interest-only mortgage. With a traditional mortgage, at the end of seven years your payments would remain the same and your loan balance would be reduced by roughly $30,000. With an interest-only mortgage, you still owe $400,000 at the end of seven years, and your mortgage payments would increase to almost $2,800 per month.
While they could be beneficial for some people in specific circumstances, interest-only mortgages come with many risks. Since you pay no principal during the initial period, you could find yourself with an “upside-down” mortgage, or owing more than the house is worth, should housing values decline. If you expect to have a significant increase in income in the next few years, you might be tempted to take out an interest-only mortgage, but if your financial situation does not improve as planned, you could find yourself with payments you cannot afford at the end of the interest-only term.
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