Although interest-only mortgages have existed for many years, they have increased in popularity recently. With home prices continuing to rise and interest rates still at low levels, an interest-only mortgage allows homebuyers to purchase a larger home with a smaller mortgage payment.
Basically, for a fixed period, you only pay interest on your mortgage. The interest rate may adjust with changes in the prime rate or be fixed for a designated period. During that period, you can typically make payments against principal at your discretion. At the end of the interest-only period, the mortgage may convert to a traditional fixed-rate mortgage payable over the remaining period of a 30-year term. Since you are amortizing the entire principal over a shorter period, the monthly mortgage payments can be significantly higher than on a traditional 30-year mortgage. Sometimes, at the end of the interest-only period, the entire balance becomes due, so you must refinance at that time.
Several types of homebuyers may be interested in this type of loan, including those who expect their income to increase significantly over the interest-only period. The lower initial payment allows them to afford a larger home. When the payments go up at the end of the interest-only period, increased income should cover the increase in the mortgage payment. Homeowners with uneven income, such as those who own their own businesses or earn commissions, may find the lower payments helpful during periods when income is lower. When their income increases, they can send additional principal payments in with their interest payments. Other homeowners may like the ability to use funds that would have been paid toward principal for other financial purposes, perhaps to fund a retirement plan or a child's college fund.
Before applying for an interest-only mortgage, be aware of the risks:
- Your payments can still increase during the interest-only period. Many interest-only mortgages are tied to the prime rate and will increase as the prime rate increases. Over a period of years, your payment can fluctuate significantly, especially if your mortgage has high caps on interest rate increases.
- Because you are only paying interest, your mortgage payments do not build equity in your home. Historically, increasing home prices have provided a significant portion of a homeowner's equity, but increases in home prices are not guaranteed. If home prices stagnate or decline, you may owe more on your mortgage than you can sell the home for.
- Once the interest-only period is over, the mortgage payment may increase substantially. If your income doesn't rise during that period or one spouse quits working, you may have difficulty finding the resources to pay the higher mortgage payment.