Is an Interest Only Mortgage Right for You?

January 16, 2014

Finding the right mortgage program for your home financing needs is important. While a typical 30 year fixed rate mortgage or 5 year ARM loan may be fine for some people, other home buyers may find that there are other options that make more sense. For home buyers who may be on tight budgets for the first few years of homeownership, an Interest Only mortgage may be a great option.

While Interest Only mortgages are not ideal for every borrower, there are some instances in which they can make a great deal of sense. But before we go into that, let’s talk about what Interest Only mortgages are, and how they work.

A typical mortgage payment consists of two main portions: the interest portion and the principal portion. With most standard loans, the interest portion begins higher and gradually decreases over the life of the loan. Likewise, the principal portion usually starts out small and gradually takes up a larger percentage of the mortgage payment as the loan goes on. When you make a mortgage payment, you are paying towards your interest balance and your principal balance. However, with an Interest Only mortgage, you only have to pay the interest portion for a specified period of time. This can be very beneficial if you are starting out with a tighter budget or lower income and are certain that your circumstances will improve.

For instance, if you are in school working toward your PhD and are highly confident that you’ll get a well-paying job after graduation, an Interest Only loan would be a reasonable choice.

An Interest Only mortgage makes sense if…

  • you currently live on a modest income but are quite sure that your income will go up in the near future.
  • you already have sizable equity in your home and plan on using the money that would go toward principal payments for other investments.
  • you rely on commissions or freelance income and want the flexibility of making minimum payments during slow times and larger payments when you have more money coming in.

Remember, an Interest Only mortgage allows the borrower to pay the interest portion of the mortgage payment for only a specified amount of time – not indefinitely. The borrower will still be responsible for paying the principal portion and any fees, but with Interest Only mortgages, the repayment of those portions are put off until a later date. Typically, the interest only period lasts between 1 and 5 years.

After the interest only period is over, the loan will re-amortize so that all of the principal and remaining interest is repaid in equal installments for the rest of the loan’s term. Interest Only loans are usually in 30 year terms, minus the number of years in the interest only period. So for example, if you took out a 30 year Interest Only mortgage with a three year interest only period, you would only pay the interest portion of your mortgage for the first three years; on the fourth year, the loan would be re-amortized to evenly spread the remaining balance over 27 years.

Here are a few more benefits of Interest Only home loans:

  • Very low initial monthly payments.
  • Option to make higher payments when you can, which is helpful for borrowers whose income tends to fluctuate.
  • After the interest only period is over, the rate and payment will not change.

To help you make an educated choice, here are a few common drawbacks to Interest Only mortgages:

  • If you only pay the required interest during the IO period, your balance will not be paid down and no equity will accrue unless your home appreciates in value during that time.
  • If your home depreciates in value, it would be easier to become “upside down” or “underwater” in your mortgage – meaning you would owe more on the mortgage than the home is worth.

Interest Only loans aren’t for everyone. Make sure you fully understand the risks and benefits involved before you agree to take out an interest only home mortgage. Talk to one of our home loan specialists at eLEND to learn more. Call 800-634-8616 today for free information and a no-obligation rate quote.

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