While the credit and housing crises make risky mortgage options much less appealing, there are times when a less traditional mortgage might be right for you. One of those is the interest-only fixed-rate mortgage, or FRM.
Interest-only FRMs allow you to cover just the interest charges on your mortgage for the first five to 10 years. After the initial period, principal payments get added to your monthly amount as you amortize your loan over the remaining term of the mortgage.
The interest-only FRM is potentially a good choice for homebuyers who have unpredictable income -- freelancers and people who work on 100% commission, for example. During the months in which your income is higher, you can make additional prepayments that will help pay down the principal. In months when you don't make as much, you can make a lower payment.
But this approach doesn't work if you spend extra income on new clothes or fancy restaurants. An interest-only FRM does nothing to make an expensive home more affordable. If a home is too expensive with a standard FRM, it will likely be too expensive when payments increase on an interest-only FRM.
Interest-only mortgages may also be a good option for homebuyers who live in a market where home prices are still on the rise and plan to move before their principal payments start. Most U.S. housing markets don't currently fit this description.
That said, there are drawbacks: With interest-only mortgages, you aren't paying down your principal at the start of the loan. As a result, after five or 10 years of making payments, you may still owe the same amount you did when you took out the loan. And while you may benefit from the reduced payments at the outset, your monthly payments will jump significantly as soon as you start paying down the principal.
To figure out how your payments would work with an interest-only loan, check out the online Interest-Only calculator from BankingMyWay.com. To start, enter your expected mortgage amount, the term of the loan, how long the interest-only portion of the loan lasts and the interest rate you expect to pay.
Let's say your lender is offering you a rate of 6.7% on a $200,000 30-year FRM with an interest-only option for the first 10 years. (Rates on a regular 30-year FRM are currently 6.54%, according to BankingMyWay.com , and rates on an interest-only FRM tend to be a little higher.) Your monthly payments would start at $1,117, then jump by nearly $400 to $1,515 after 10 years, when you start making principal payments in addition to your interest payments.
It is this sudden increase in payments that places unwitting homeowners in financial jeopardy. But if you plan ahead for this increase -- and take advantage of the loan's flexibility by making significant prepayments when you can -- the start of your amortization period won't cause as many problems.
If you make an average prepayment of $200 a month over those first 10 years, you'll gain a $24,000 head start for when you start paying down your principal. Better yet, as of your first prepayment, you'll have lowered the amount of your next interest payment to $1,116. That's a reduction of just a dollar, but it highlights an important point: Most interest-only mortgages calculate how much interest you owe each month. As a result, prepayments not only lower your principal but they also lower your future minimum monthly payments.
As with all mortgage applications, make sure you understand the details of your loan fully before making a final decision, and discuss any questions with your lender before closing.