Here’s How [They] Work

by Tara Mastroeni, Contributor
FORBES – Real Estate

Many buyers have heard about interest-only mortgages and the low payments that they promise. While they aren’t very common anymore, it is still possible to get one of these loans. However, if you’re considering going this route, you need to know what to expect. Read on to learn what an interest-only mortgage is, how it works, and what the pros and cons are of signing on the dotted line.

What is an interest-only mortgage?

Every mortgage has two main parts: the principal and the interest. The principal is the amount of money that you borrow to buy the home and the interest is what that you pay the mortgage company in exchange for letting you borrow the money.

Traditionally, when you make your mortgage payment each month, a portion of the money goes toward paying the interest on the loan and a portion goes toward the principal amount. Over time, the percentages of those portions will change. However, with either a fixed-rate or an adjustable-rate mortgage, you’ll always be paying down both segments at the same time.

With an interest-only mortgage, on the other hand, you’ll be given a certain period of time where you’ll only have to make payments on the loan’s interest. After that initial period is over, your monthly payment will change to include both the principal and interest amounts.

How interest-only mortgages are structured

Typically, the interest-only period on an interest-only loan will last for either five or ten years. During that time, you’ll have the option of making larger-than-necessary payments – the excess of which would go toward paying down your principal amount – but it’s not required. After that time, you’ll have the rest of the life of the loan – usually 10 or 20 years – to pay off the entire principal balance plus any interest that’s accumulated.

Interest-only loans usually function similarly to adjustable-rate loans. During the interest-only period, the interest rate is usually fixed, but after that, it can go up over time.

If you’re considering this type of mortgage make sure that you get clarification from your lender on how often the interest rate will change and how high it can ultimately go.

The benefits of an interest-only mortgage

Mortgage payments are usually the biggest expense that homeowner’s have on their plate, which can make interest-only mortgages seem all the more appealing. During your interest-only period, you may be able to take advantage of the lower payments to pay off other debts like student loans or to rebuild your savings after covering your down payment and closing costs.

Interest-only mortgages are unique in that it may even be possible to write off the entirety of your payments during the interest-only period under the mortgage interest tax deduction.

The drawbacks of an interest-only mortgage

The biggest drawback to an interest-only loan is the inevitable change in payment. Once your interest-only period is over, your payment is going to raise substantially. If your new payment is too large for you to handle, you could risk facing foreclosure.

The other thing to consider is the unpredictability of your interest rate. While you’ll likely be given a low rate during the interest-only period, afterward, the interest on adjustable-rate loans tends to be higher than what you might find with a fixed-rate option.