Tempting Interest Only Mortgage
The Good, Bad, and Ugly of an Interest Only Mortgage
An interest only mortgage can appear to be a very attractive offer at the onset. However, it can also be a disaster waiting to happen for many borrowers who don’t completely understand what awaits them five or ten years down the road.
About ten or twelve years ago, a period known as the Great Recession caused havoc for many homeowners. One of the causes of this economic ruin was interest only mortgages held by borrowers who bought expensive homes they couldn’t afford. When the interest-only period ended and they had to begin repayment of principal also, and a higher rate of interest, they defaulted. have brought this option back for certain home buyers. The question we have is, should a home buyer ever consider taking on an interest only mortgage?
The structure of an interest only mortgage.
First of all, let’s see what it is not. On a traditional type mortgage with a fixed rate, you make a monthly payment of principal and interest for a certain number of years. At the end, the loan is paid in full.
With an interest-only mortgage, you repay interest only for a five or ten year period at a fixed rate of interest. During this period, your monthly payment is lower because no principal is being paid. At the maturity of the interest-only period, the principal balance of your mortgage is the same as the amount originally borrowed.
When the interest-only term is up, your monthly payment will revert to a principal and interest amortization. Often times, the interest rate reverts to an adjustable rate, and you now have a much higher monthly payment.
Current interest-only mortgages have new criteria
A decade ago, lenders and real estate developers were selling homes to individuals who clearly couldn’t afford them. They offered a low rate for interest-only loans basing their credit approval for income on the interest amount only. When it came time to start paying principal also, many borrowers didn’t have a clue this would happen, and they ended up in foreclosure.
Today, hopefully, lenders have learned their lesson…at least, they have more stringent requirements as to whom to offer an interest only mortgage. The following terms are fairly common in the lending industry and may vary slightly by a few.
- A minimum down payment of 20%.
- Only high credit score borrowers can qualify
- The income requirement is based on the full payment of principal and interest at maturity.
The good and the bad of interest only mortgages
Initial payment on the loan is small just paying the interest. This gives you the freedom to use the cash not paid on the principal for some other purpose. However, you need to remember that an interest-only loan carries more risk than a traditional fixed rate loan.
- During the time that you’re only paying interest, there is no equity build-up in your home. If for whatever reason, property values in your area decline, you can be underwater on your mortgage. If you need to sell your home during this period, you might not clear enough to repay the mortgage.
- During the interest-only term, your monthly payment is low and many individuals tend to spend what they earn. When its time to start paying principal and interest, it can be difficult finding that extra amount that’s now required.
- After the interest-only period ends, most of these loans revert to a variable rate. If interest rates are rising, your monthly payment will rise as well. Rates are beginning to rise and there are expectations they will continue that way for some time. It’s best to lock in a rate with a fixed rate now to protect yourself from these increases.
- There are many calculators on the internet that you can use to see that you’ll pay a lot more interest with an interest-only mortgage than a traditional fixed rate over the term of the loan. It’s easy to see because, during the initial interest-only term, no principal is being paid.
We have an example of this to show you. Say that you bought a home for $300,000.00 and are paying 20% down, and will have a mortgage for $240,000.00. Using an interest rate of 4% with an initial period of 10 years paying interest only and a total term of 30 years. Over the total life of this loan, you would pay $205,000.00 in interest.
If you took out a fixed rate traditional loan paying principal and interest with the same terms, you’d pay $172,500.00 in interest over the life of the loan. A savings of $32,500.00!
[KiwiClickToTweet tweet=”Interest only loans are okay for certain borrowers in certain circumstances but are usually a bad idea for most.” quote=”Interest only loans are okay for certain borrowers in certain circumstances but are usually a bad idea for most.”] For one, you may be tempted to buy more home than you can afford and when regular amortization begins, you may be struggling.
We don’t recommend an interest only mortgage for that reason. There are so many possible ways it can make your life a nightmare.