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Interest-Only Mortgages

Interest-only mortgage payment options can be available on ARMs or fixed rate loans.  During the I-O period, borrowers can delay making principal payments and make monthly payments that include only the loan’s interest. After the interest-only period ends, however, if interest-only payments were made (you can choose to make regular principal + interest payments during the I-O period) your monthly payments will significantly increase when your required monthly payments start to include principal, plus interest.

Adding any unpaid principal from the first 10 years to the principal due on the remaining years of the loan plus interest due on the remaining portion of the loan can result in what is commonly referred to as “payment shock.” You should carefully consider payment shock when considering an I-O payment option. Interest-only mortgages start with monthly payments that include only the loan’s interest.

After this initial interest-only period ends, however, the monthly payments can significantly increase when these payments then start to include the principal. This is called amortization. When an interest-only loan starts amortizing, the monthly payment amount increases, as you begin repaying principal in addition to interest.

What are the advantages of interest only mortgages?

You can use an interest only loan to purchase an expensive home with a much smaller monthly payment than if you had a conventional loan.  This frees up money that you may want to put to better use.  

If your income is varies because your work is commission based, an interest only loan may make sense because it keeps your monthly payments small and when you are paid, you can then make larger payment against your principal.

Interest only loans are used by speculative real estate investors who are betting that the value of the home will rise substantially offsetting the cost of having the loan.  They plan on selling the home in a few short years with a profit, even though the balance of the loan hasn’t changed.

What are the disadvantages of interest only mortgages?

The main disadvantage of interest only mortgages is that you will build no equity in your home, thus you are not building wealth.   Since you have no equity, you will not be able to borrow later with a second mortgage. If your home loses value, you more than likely will have to pay to sell your home.  

With an interest only mortgage, you are basically servicing a debt because you don’t reduce the balance of your loan.  Keep in mind that at some point you will have to pay the money back.  Your bank may ask that you pay back the principal back after 10 years or so, which you should be aware of upfront.

You will eventually end up selling the home or refinancing the mortgage to pay off your interest only loan.  But keep in mind, in the long run, this could cost you dearly.  For example, lets say you purchased a $200,000 home with 20% down ($40,000), so your borrowed $160,000.  Over several years you make interest only payments, but the home loses value and is now worth $130,000.  You decide to sell, but you will only get back $10,000 (not excluding fees).  You lost a whopping $30,000.  If the value of your home falls below $120,000, you will have to pay at closing.

 

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