Why Interest Only Mortgages Are Complicated Products

Buying a home with the help of a mortgage is one of the most significant financial commitments that you can make in life. To save money on housing costs, you can explore taking advantage of an interest-only loan. Be advised, however, that an interest-only loan is a complicated product best reserved for sophisticated real estate buyers. An interest-only mortgage exposes you to payment shock, when your monthly housing costs increase dramatically.

Interest-Only Mortgage Structure

With an interest-only mortgage, you will not make mortgage principal payments for a set time frame. After making interest-only payments, you can expect your monthly mortgage bill to increase significantly, as the principal balance amortizes over a shorter period of time. For example, you may be forced to pay off $250,000 in principal over the course of 25 years, instead of 30, after making interest-only payments for the first 5 years of the mortgage.

A pay option adjustable-rate mortgage (ARM) may be described as a version of an interest-only loan. With the pay option ARM, you can choose to make interest-only payments, regular principal and interest payments, or a minimum payment. The pay option ARM features a variable-rate structure, where your interest rate shifts according to the prevailing economy.

Interest-Only Mortgage and Affordability

You would consider an interest-only loan, if you expect to make more money in the near future. As a medical resident, you may take out an interest-only mortgage--with the expectation that your salary will be set for an immediate increase when you matriculate as a full-time practicing doctor. Because of credit concerns, you may rely upon interest-only financing to buy a home when you are unable to qualify for a standard mortgage with principal and interest payments.

Interest-Only Mortgage and Real Estate Investments

As a sophisticated real estate investor, you may take out an interest-only mortgage to add more financial leverage to your holdings and flip property. Leverage describes a series of transactions where you borrow money to purchase assets that generate cash flow. For example, you could reinvest your interest-only mortgage cash savings back into the property to enhance its value with the installation of hardwood floors, crown molding, and stainless steel appliances. After these upgrades, you may then sell the property within the next year and pay off your loan at a large profit. Beyond simply flipping one home, you could leverage multiple interest-only mortgages to to buy additional properties and build a substantial real estate portfolio.

Warning

Interest-only mortgages are especially risky in a down real estate market. When you make interest-only payments, you are not establishing equity, or financial ownership. In recession, you are therefore likely to owe more on your home than it is actually worth. At that point, you would be more so at risk for foreclosure, because you would be unable to sell the home for enough cash to immediately pay off the loan, if financial difficulties were to arise. Again, interest-only loans also expose you to payment shock, when the loan adjusts and forces you to make principal and interest payments that you cannot afford. Because of these complexities and risks, the interest-only mortgage is best reserved for high earners and experienced real estate buyers.

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