While interest-only mortgages promise low payments, they aren’t very common these days. It still is possible to get one of these loans, however, and if you’re considering going this route, you need to know what to expect.
Here, Forbes explains what an interest-only mortgage is, how it works, and the pros and cons of signing on the dotted line.
What is an interest-only mortgage?
Every mortgage has two main parts: the principal and the interest. The principal is the amount of cash borrowed to buy the home, and the interest is what is paid to the mortgage company in exchange for borrowing the money. When you make your monthly payment, a portion of the money goes toward paying the interest on the loan and a portion to the principal.
The percentages of those portions will change over time, but you’ll always be paying down both segments at the same time with either a fixed- or adjustable-rate mortgage.
With an interest-only mortgage, however, you’ll be given a certain period of time where you’ll only have to make payments on the loan’s interest. After that initial period is finished, your monthly payment will change to include both the principal and interest amounts.
How interest-only mortgages are structured
The interest-only period on an interest-only loan typically lasts for five or 10 years. During that time, you’ll have the option of making larger-than-necessary payments (the excess of which would go toward paying down your principal amount), but it’s not required.
After that time, you’ll have the rest of the life of the loan (usually 10 or 20 years) to pay off the entire principal balance, plus any interest that’s accumulated. Interest-only loans usually function similarly to adjustable-rate loans.
During the interest-only period, the interest rate usually is fixed, but it can go up over time afterward. If you’re considering this type of mortgage, be sure to talk to your lender about how often the interest rate will change and how high it could ultimately go.
The benefits of an interest-only mortgage
Because mortgage payments usually are the biggest expense that homeowners have, interest-only mortgages can seem quite appealing. During your interest-only period, you may be able to take advantage of the lower payments to pay off other debts like student loans, or to rebuild your savings after covering your down payment and closing costs. It might even be possible to write off the entirety of your payments during the interest-only period under the mortgage interest tax deduction.
The drawbacks of an interest-only mortgage
Once your interest-only period is complete, your payment will increase substantially, and if your new payment is too large to handle, you could risk facing foreclosure.
In addition, while you likely will be given a low rate during the interest-only period, the interest in adjustable-rate loans often winds up being higher than what you might find with a fixed-rate option.
