An interest-only mortgage is one that gives you the option of paying the interest, or the interest and as much principal as you want in any given month during an initial period of time. Interest-only loans can be 30-year fixed rate mortgages or adjustable rate mortgages. Most mortgage companies offer home loans that are interest only for the first three, five, seven or 10 years.
If you choose to make the interest-only payment, your monthly payment will be lower than it would be with an interest and principal payment. Although your interest rate may or may not be lower than a traditional mortgage, you gain the option of flexible payments. Interest-only loans allow you to control your payment amount and your cash flow in any given month during the interest-only period.
When to Consider an Interest-Only Mortgage
There are good reasons to consider an interest-only mortgage. For instance, it might make good financial sense. Here is how:
On a traditional 30-year fixed rate mortgage, roughly 70% percent of the payment goes toward interest during the first six or seven years of the loan. If your interest rate is low, then you have borrowed at a good rate.
Instead of paying down the low-rate loan, you could take the extra money you save each month from making only interest payments, and invest it in something that should bring you a higher rate of return, or you could pay down high-interest debt like credit cards.
Depending on your loan amount, you could have access to thousands of dollars over the course of several years to invest or reduce your high-interest debt.
But what about building equity?
A common misconception about paying on an interest-only loan is that you are not paying down the principal, thus you are not building equity. Not necessarily true: Homes in the United States have been appreciating between 5% and 6% a year. Chances are that even if you are not paying down your principle, you are building equity in your home through appreciation.
Bottom Line
Interest-only loans may also be good option for people who expect to be in their homes for less than 10 years. As previously mentioned, mortgage payments are mostly interest for the first few years of the loan. Many homeowners like the option of making interest-only payments and using the extra money as they please — saving for college tuition, making home improvements, etc. Interest-only loans generally do not have a pre-payment penalty; therefore, you can refinance anytime.
