We know: All About Interest-Only Mortgages

What's an interest-only mortgage?

Interest-only mortgages are mortgages in which you pay only the interest on the loan, instead of the interest and a portion of the principal each month.

These mortgages are have an interest-only term that can last 5, 10 or 15 years. Usually the interest-only period is 5-7 years. At the end of the term, you usually must refinance or begin to pay off the principal, along with the interest. This means your payments will probably increase.

What are the advantages of an interest-only mortgage?

These mortgage loans can be helpful to people who expect to earn more in the future (so that they can afford an increased payment), people who's income is irregular (like commission earnings), and people who are willing to risk taking the money they will save on a interest-only loan and invest it in something that will earn them a good return.

If you earn your living through commissions or bonuses and want to use your spikes in income to pay off the principal when you can afford it, be sure there is no prepayment penalty on the loan.

What are the disadvantages of an interest-only mortgage?

Interest-only mortgages are not a good idea for people whose incomes are likely to remain the same or only increase modestly because:

  • when the interest-only period of the loan ends, you either have to refinance or be prepared to pay a larger monthly payment that includes payment on the principal
  • throughout the first part of the loan, you are not accruing equity in the house (only appreciation, which may or may not happen, depending on the housing market)
  • when the interest-only period of the loan ends, you still owe the entire principal and, because the term of the loan has been shortened (usually by 5-7 years), you have fewer years to pay it off and monthly payments will be higher

What else should I be aware of with an interest-only loan?

Be aware of how the interest rate on the loan works.

If you get an adjustable interest rate, then your principal payments with fluctuate with the rate and could rise, just as well as falling.

If you get a fixed rate for the interest-only period of the loan, and the rate is readjusted at the end of the period, rates could rise (as well as fall) and you could have an even bigger monthly payment.

If you plan to refinance at the end of the interest-only period, they you are again betting that rates will fall. And betting means risk.

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