Monday, February 23, 2009

When to Choose an Interest-Only Mortgage

An interest-only mortgage is just what the name suggests. It is a loan in which you are only paying the interest amount and not the principal. However, most interest-only mortgages only allow you to pay just the interest amount for the first five or ten years of the loan term. After that period you would then have to pay the full monthly amount, based on the total amount of the loan.

Interest-only mortgages are sometimes perceived as risky or gimmicky, although for many buyers they do offer flexibility and the chance to buy a home with lower monthly payments. Interest only mortgages aren’t exactly a particularly new concept, they were actually popular back in the 1920’s until the depression came along. In the last few years they have become increasingly popular as several large respected lenders have offered them; in some more expensive areas of the US, interest-only mortgages have accounted for around 50% of all new mortgage loans.

Suppose you buy a $200,000 home and take out a 30 year mortgage with an interest rate of 6.5%. For the first five years of the loan, you pay just the interest amount, which is going to be around $1080 per month. The majority of your monthly payment during the first few years is the interest, rather than the principal. After five years, the loan balance remains the same, but the monthly payments are recalculated to what would be the amortized amount, making the monthly payment more like $1260. During those first five years, your monthly payments are almost $200 lower, a big difference. If you buy a more expensive home, the savings are even greater.

You may want to choose an interest-only mortgage if you are a first time homebuyer and not used to making monthly payments that are probably higher than you were paying in rent. If your income fluctuates, you work freelance or on commission, it gives you the option to perhaps buy a more expensive home but to still have more affordable payments. An interest-only mortgage is often seen as an effective way to buy a more expensive home than you might otherwise be able to afford. This shouldn’t be your only reason for taking this option.

An interest-only mortgage is also an ideal option for those who know that they will have more income in the next few years, perhaps with a pay raise. Then they know they will be able to afford higher monthly payments. And if you are fairly sure that you will be refinancing your loan sometime in the next few years, an interest-only mortgage may be an ideal option for you. If you feel you can pay more in a particular month, there is usually no prepayment penalty on the loan. This type of loan is very flexible; it also offers options for different terms, usually five, ten or fifteen years.

One of the big advantages of an interest-only mortgage is that you have the option of paying towards the principal if you want to. You aren’t required to pay extra; but it is an option if you can afford it. An interest-only mortgage allows you to not only buy a more expensive home with a smaller monthly payment; it also allows you to free up money that you may need for other things, such as home improvements, college tuition for your children or a retirement fund. Arguably, this type of mortgage also makes it easier to budget for those other important things, especially for a homebuyer who is just starting out.

Just as with a more conventional mortgage, an interest-only mortgage can come with a fixed rate or an adjustable rate. A fixed rate mortgage has the big advantage of stability. Meaning that the interest rate on your loan won’t change, regardless of the economy and regardless of whether interest rates go up or down. An adjustable rate mortgage can go up or down, as the rate is set against the overall interest rate at the time. Although if you’re monthly payments are much less anyway, a small increase in your monthly payment amount may not affect you too much. However, even with a fixed rate interest-only loan, the rate may change at the end of the interest-only loan period.

An interest-only mortgage is absolutely not for everyone. Whether or not it can work for you; depends on your short term goals, your financial situation and your capacity for risk. As with any type of loan, there are drawbacks. The biggest one being the higher monthly payment that takes effect after the interest-only period has elapsed. Always consult with your financial advisor before making the decision to apply for an interest-only mortgage. There will be certain people pointing you in different directions, but in the end the choice is yours.

About the Author

Shawn Thomas is a freelance writer who writes about topics and financial products pertaining to the mortgage industry such an adjustable rate mortgage available from a mortgage lender

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