What’s an Interest Only Mortgage?

Read This before Considering an Interest Only Mortgage

In today’s day and age, everyone wants more than they can afford and houses are no exception. Thanks to a mortgage type referred to as an interest only mortgage, home buyers have been able to get into homes that would normally be out of their price range. However, while an interest only mortgage may seem like the ideal solution on the surface, when you dig a bit deeper you may discover that an interest only mortgage isn’t always the best choice.

Why Interest Only Mortgages are Appealing

Let’s say you want to buy a home and you have to keep your payments under $1,000 a month. With a traditional 30-year fixed-rate mortgage at an interest rate of 6.25 percent, you would only be able to mortgage $160,000.

However, if you took out an interest only mortgage with an interest rate of 5.75 percent, you could afford a mortgage of up to $200,000 and would still be able to keep your payments under your $1,000 a month cap. That’s a $40,000 difference in the price of the home you would be able to afford.

How an Interest Only Mortgage Works

To understand the problem with an interest only mortgage, you first need to understand what an interest only mortgage is. When you take out an interest only mortgage, the payments you make at the beginning of the loan are interest only payments, meaning you don’t pay any of the principal — you just pay interest on the loan. The length of the interest only period depends on how the interest only mortgage was set up when you took it out. Normally, interest only periods last from five to ten years.

After your interest-only period is over, you begin making payments on both interest and principal so your mortgage payments increase. For many people this isn’t a problem since their incomes also increase during the course of the interest only mortgage. If the person can’t afford the payments once the interest-only period is up, they can either refinance into another interest only mortgage or they can sell the house and buy a house they can afford. However, there are variables here that we need to discuss.

The Pitfalls of Interest Only Mortgages

The first thing you need to look at when taking out an interest only mortgage is whether it’s a fixed rate interest only mortgage or an adjustable rate interest only mortgage. If the interest only mortgage you take out is a fixed rate, you know exactly how much your mortgage payments are going to be when your interest-only period is up. However, if you take out an adjustable rate interest only mortgage, you have no idea what your payments are going to be when the interest only period is over and if interest rates rise significantly, you may find yourself in a pickle.

If you absolutely cannot afford the payments when your interest-only period ends and the value of your home has not increased enough, you won’t be able to sell the house for enough money to pay off the mortgage and you won’t be able to refinance the home either. That could cause some serious problems.

The Bottom Line

My advice is this. If you plan on living in your home forever and it is at all possible for you to afford it, you should take out a traditional fixed-rate mortgage for a period of fifteen to twenty years. If you plan on selling your home after a few years or you just can’t afford the payments on a suitable home, I would go ahead and take out an interest only mortgage, but I would never take out an interest only mortgage with an adjustable interest rate.