With an interest-only mortgage, the homeowner only pays interest for five to 10 years. After that period ends, the homeowner can begin to make significantly higher payments that include both interest and principal, pay a lump sum or refinance the mortgage.
Reasons to Consider an Interest-Only Mortgage
An interest-only mortgage might make sense if you planned to live in a house for a relatively short time. Interest-only loans are also popular with buyers who flip houses and want to have cash available for renovations.
Lenders consider debt-to-income ratio when deciding how much to allow a homebuyer to borrow. If you opted for an interest-only loan with low monthly payments, you would be able to buy a more expensive house than you could otherwise, since the low payments would have less of an impact on your monthly obligations than a large mortgage payment would.
If your income is currently low but you expect it to increase significantly in the future, it might make sense to have low interest-only payments now and start paying off the principal later. If your income fluctuates throughout the year, an interest-only mortgage could give you the flexibility to adjust your payments based on your income each month.
Only paying interest for several years could allow you to put money toward other goals. You might be able to invest funds in the stock market or a business, earn a high rate of return and increase your net worth.
Risks Associated With an Interest-Only Mortgage
An interest-only mortgage could be risky. If you expected your income to increase significantly, but it didn’t, you might be unable to afford the higher mortgage costs when the interest-only period was over.
If you only paid interest for several years and didn’t put any money toward the principal, you wouldn’t build equity. If housing values fell, you might be unable to sell the house or refinance the mortgage since you would owe more than the property was worth.
With an interest-only mortgage, some borrowers choose an adjustable-rate so they can make minimum payments that don’t cover all the interest due. If you chose that option, you could wind up owing even more than the balance at the start of the contract, which could make it difficult or impossible to refinance.
Some lenders allow borrowers with interest-only mortgages to make payments toward principal, but others charge prepayment penalties to discourage that. If you want the ability to make extra payments or refinance before the interest-only period ends, ask if the lender charges a prepayment penalty so you don’t get hit with an unexpected fee.
Is an Interest-Only Mortgage a Good Choice for You?
An interest-only mortgage makes sense for homebuyers in certain circumstances. Unfortunately, some homebuyers use it to buy an expensive house and put off making payments, then find themselves in financial trouble. Carefully weigh the pros and cons and talk to a mortgage professional before deciding whether to take out an interest-only home loan.
