What is an Interest Only Mortgage?
An interest-only mortgage is a type of mortgage loan where the borrower is only required to pay the interest on the loan for a certain period of time, typically between five and ten years. During this time, the borrower does not have to make any principal payments, which means that the monthly payments are lower compared to a traditional mortgage.
At first glance, an interest-only mortgage may seem like an attractive option for those looking to lower their monthly payments. However, it's important to understand how this type of mortgage works and the potential risks involved.
How does an interest-only mortgage work?
With an interest-only mortgage, the borrower is only required to pay the interest on the loan for a set period, usually between five and ten years. After this initial period, the loan typically converts to a traditional mortgage, where the borrower is required to make both principal and interest payments.
During the interest-only period, the monthly payments are lower since they only cover the interest charges. This can be beneficial for borrowers who need some flexibility with their monthly budget or who anticipate an increase in their income in the future.
Advantages of an interest-only mortgage
Lower monthly payments
One of the main advantages of an interest-only mortgage is the lower monthly payments during the initial period. This can free up cash flow for other expenses or investments.
Flexibility
Interest-only mortgages provide borrowers with flexibility in their monthly budget. This can be particularly helpful for those who have irregular income or are expecting an increase in income in the near future.
Locks in a Home
As of the date of this post, interest rates are at a high not seen in over 20 years. Using an interest only loan will lock in the home you want today potentially saving you money as you lock in todays price on a home that could be much more expensive in a few years.
Avoids Bidding Wars
Once rates do begin to come down, a lot of buyers will be ready to buy. All of those that said they are waiting for rates to drop will be bidding on homes. That means a there's a good chance bidding wars will come back. You would already be in your home and you can still take advantage of lower rates by refinancing out of the interest-only mortgage into a lower interest fixed mortgage.
Disadvantages of an interest-only mortgage
No equity build-up
Since the borrower is only making interest payments during the initial period, there is no principal reduction. This means that the borrower is not building equity in their home until they start making principal payments.
Higher long-term costs
While the monthly payments may be lower during the interest-only period, the long-term costs of an interest-only mortgage can be higher compared to a traditional mortgage. This is because the borrower is not paying down the principal balance, which means they will end up paying more in interest over the life of the loan.
Is an interest-only mortgage right for you?
Deciding whether an interest-only mortgage is right for you depends on your individual financial situation and goals. If you are confident that you will be able to afford the higher monthly payments once the interest-only period ends and you understand the potential risks involved, it may be a suitable option.
However, it's important to carefully consider your long-term financial goals and consult with a mortgage professional before making a decision. They can help you evaluate your options and determine the best mortgage product for your needs.
Ultimately, an interest-only mortgage can be a useful tool for certain borrowers, but it's important to thoroughly understand how it works and the potential implications before committing to this type of loan.