An Introduction to Interest-Only Mortgages

An interest-only mortgage is a loan secured by real property that contains an option to make interest-only payments. The borrower need not make interest-only payments, but has the option of doing so. This is helpful to borrowers, particularly first-time home owners, who come suddenly up against unexpected bills. Rather than paying both the principal and interest in a given month, the borrower can elect to pay only the interest, so that he or she can tend to their unforseen expenses.

Most interest-only mortgages do not permit borrowers to make interest-only payments indefinitely. Typically, the period in which borrowers can make interest-only payments is limited to the first five or ten years of the loan.

There are many critics of interest-only mortgages, who consider these loans to be risky, since the borrower, if not careful, can find him or herself making interest-only payments for years and years and never gain any equity in the home. However, for disciplined home buyers, this can be an excellent way to help protect themselves against unforseen circumstances. This is also helpful for individuals whose salaries may fluctuate from month to month, such as self-employed individuals, freelancers, and salespeople who depend heavily on their commissions. If such individuals experience a slow or bad month, they can avoid paying toward the principal on their mortgage, which ranges and could amount to hundreds of dollars or more. If the individuals so choose, they can pay more toward the principal when business is good, or commissions or bonuses are finally received.

Of course, one downside to interest-only mortgages is that the cost is somewhat higher than for traditional loans. For instance, lender fees are typically greater, and the interest may be half a percent or more higher. Because essentially, interest-only mortgages can serve as a type of insurance against hard times for the home buyer.

There is also some risk involved. If the property does not appreciate in value, and the borrower takes full advantage of the interest-only mortgage by paying only interest for the first few years, the borrower will owe the same principal balance with no equity in a property that is worth the same amount as when he purchased it. A larger down payment at the time of purchase is one way to reduce the risks inherent in interest-only mortgages. Unless, of course, the property actually depreciates. Then the home buyer may lose all the equity he has put into the property. But that is a risk faced by all home buyers and real estate investors in a falling market.

The best way to reduce the risks associated with an interest-only mortgage is to use the loan as it was meant to be used. In other words, home buyers should pay the monthly principal and interest on the mortgage, unless and until they truly need to utilize the interest-only provision. For example, if they face unforseen expenses for a month or two. Borrowers should return to paying both principal and interest as soon as circumstances permit. Then an interest-only mortgage could work to their advantage.