Interest-only mortgages are making a comeback after a brief lull on the mortgage landscape.
Interest-only mortgages were both pervasive and precarious in the years leading up to, and including, the Great Recession of 2008-2009.
At that time, mortgage lenders packaged and sold interest-only mortgage loans to higher-risk homebuyers, who were looking for ways to keep their mortgage payments as low as possible.
Interest-only mortgages fulfilled that promise - up to a point.
What Is an Interest-Only Mortgage?
In essence, these mortgages allowed homebuyers to pay just the interest on their mortgage loans, and not the loan principal and the interest.
The caveat with interest-only loans is a big one - the interest-only payment allowance was only for a fixed period.
That fixed period is up to the lender, but when it expires, the borrower is expected to pay the mortgage loan principal and interest, thus hiking the total monthly mortgage payment by hundreds of dollars in most cases. During the recession, over nine million Americans lost their homes between 2006 and 2014, many of them tied to interest-only mortgages.
Given their controversial past in the recession years, interest-only loans are nowhere as abundant as they were a year ago, comprising about 1% of the total U.S. mortgage market, according to the Mortgage Bankers Association.
Even so, a deeper dive into interest-only mortgages is warranted, now that these mortgages are edging their way back into the consumer mortgage experience, even if they come equipped with safer standards and policies.
Who Benefits From an Interest-Only Mortgage?
Certain mortgage consumers may gain an advantage from an interest-only mortgage more than others:
- Anyone who wants to curb their initial mortgage payments. Mortgage borrowers who want to cut their mortgage payments for a fixed time can benefit from an interest-only mortgage, especially borrowers who plan on getting out of the home before the higher payments kick in.
- Anyone with an expectation of a much higher income down the road. If you're expecting to come into serious money in a few years (for example, you're a medical school student who'll be a surgeon in five years), an interest-only mortgage loan can make good sense. You'll save money earlier, then be able to handle the higher payments down the road.
- If you've bought a new home but still own your old home. If you've purchased a new residence but are still hanging onto your old home, money could be tight. In that scenario, having a lighter loan payment early can help you save some money until you sell the old home.
- If you want more money to invest. Interest-only mortgage consumers may just want to steer more money into stocks, bonds and other investments during the first few years of their loans. After all, the more money you save on your initial mortgage payments, the more cash you'll have to make a bigger profit in the financial markets.
The primary downside of an interest-only mortgage payment is a big one - you aren't building equity on your home investment.
That's because, during the interest-only time period, the cash you're paying toward your home isn't going to principal, which helps build equity. Instead, it's only going to the interest payments, which doesn't build any home equity.
How Do Interest-Only Mortgages Work?
By and large, interest-only mortgages are structured like traditional mortgages, packaged with 30-year terms. The key variation is in the interest-only repayment period.
With interest-only mortgages, the interest-only payment time frame generally lasts 10 years. In that period, the mortgage loan borrower pays only the interest on the loan, keeping monthly mortgage payments low for cash-strapped homeowners. Meanwhile, the mortgage principal remains unpaid, and the meter keeps rolling on that principal's accrued interest.
Take a 30-year mortgage for $100,000 at an interest rate of 6.25%. In an interest-only repayment period, the monthly loan payment would be $520.83. Take the interest-only component away, however, and the payment rises to $615.72 when mortgage principal and interest repayment is required.
The higher the loan, the bigger the sticker shock when an interest-only payment period expires, and the mortgage holder has to pay the higher monthly mortgage amount.
Consider a $300,000 interest-only mortgage, even with a lower interest rate of 4%.
In a traditional 30-year fixed rate mortgage, the monthly payment stands at $1,432. But an interest-only mortgage under the same terms yields a much lower monthly payment for a 10-year fixed year interest-only time period.
In that scenario, the homeowner only pays $1,000. Once the interest-only repayment period expires, and the mortgage borrower resumes paying the whole freight, that monthly mortgage payment rises to $1,818 for the next 20 years.
That hike in monthly payment underscores the risk mortgage loan borrowers take when they rely on an interest-only mortgage. Even if they sell the home before the 10-year interest-only period runs out, they're still on the hook for the rest of the amount owed on their mortgage, which needs to be repaid in full - and they still haven't built any equity in the home.
What to Know About Interest-Only Mortgages
If you're still committed to landing an interest-only mortgage, make sure you know exactly what you're getting into and understand the jarring reality of a mortgage payment rising by $400 or $500 a month once your interest-only payment period expires.
Know your dates and time frames. Before you sign on the dotted line on an interest-only mortgage, talk to your mortgage lender and fully understand the exact terms you're agreeing to when taking on the mortgage.
You'll want to know the exact amount of your interest-only payments, how long the interest-only payment period lasts, how much your mortgage will cost (monthly and total) once that time period expires. If you're taking on too much in terms of those remaining payments, it's best to lower your price target-range and buy a less expensive house.
Go ahead and make your principal payments, anyway. If you're locked into an interest-only mortgage, that doesn't mean you can't pay extra toward the principal owed on the mortgage during the fixed interest-only payment period.
Let's say you landed a new job that pays more money, or you received a big inheritance. With more cash on hand, you can pay both the principal and the interest, and thousands of dollars on the total cost of your mortgage.
Pay as large a down payment as possible. The more money you put down upfront, the less you'll have to pay for the entire mortgage loan. Interest-rate loans usually demand higher down payments (between 10%-and-30% on most loans), so paying more upfront is your best insurance policy against rising monthly mortgage costs.
Don't treat it as a gamble. If you're taking out an interest-only mortgage loan in the hopes that your home will grow in value, you could be making a bad bet. In the real world, homes can decline in value and homeowners can lose their jobs and income. It's a better bet to wait until you really afford the home you want, using a traditional 20-year mortgage, and start building wealth equity right away.
Go into an interest-only mortgage loan with your eyes wide open. Know that your mortgage payments will rise and know that, by not making principal payments, you're not building any equity in your new home.
And, if tragedy strikes and you lose a job or get divorced and can't afford the home's rising mortgage payments, know that your next step could be bank repossession and foreclosure - a spot no homeowner wants to be in.
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