There are several types of interest only mortgage loans. Of course, the interest only mortgage loan method of mortgage financing has its pros and cons, just as anything else.
Interest Only Mortgage: The Pros
1. Interest only mortgage loans have a lower payment than a standard amortized loan. For example, if you took out a $200,000 loan- principal and interest- your monthly payment would be $1264 (and some change) with an interest rate of 6.5%
If you borrowed $200,000 with an interest only mortgage, also at 6.5%, your monthly payment would be $1083.
The interest only mortgage payment would save you approximately $181 per month.
2. Interest only mortgage loans allow you to buy more house. When it comes to qualifying for a mortgage, a borrower qualifies for the monthly payment, not the loan amount per se.
So, using our example from above, if a borrower only qualified for an $1100 per month loan payment, but the borrower wanted a $200,000 loan, the borrower could qualify if he or she opted for an interest only mortgage at only $1083. (This is based on an interest rate of 6.5%. This article does consider changing interest rates.)
Interest Only Mortgages allow people to buy homes they wouldn’t otherwise qualify for.
3. Interest only mortgage loans provide the borrowers a little wiggle room. Let us say that you take out an interest only mortgage loan, but you have every intention of paying down your loan as if it is fully amortized.
Every month, you choose to pay $1264, because that is what the principal and interest payment would be. However, you are only required to make the interest payment of $1083. That way, if times are tight (medical bills, etc.), you can fall back on the interest only payment if you have to. You can save a couple of hundred dollars per month, for a few months, and then it’s back to your original financial plan.
The interest only mortgage loan gives you some wiggle-room if you ever need it.
4. Interest only mortgage loans may be ideal for investment properties / a.k.a. rental properties. Again, using the example from above: If you were to purchase an investment property for $250,000 and put $50,000 down, you would have a loan amount of $200,000 of course.
In , Arizona for example, rents on homes (single family residences) tend to be in the $1000 range.
If the landlord chose an interest-only loan for his or her investment property, the rent may actually cover the mortgage payment.
Interest Only Mortgage: The Cons
1. Interest only mortgage loans are never really 100% “interest only.” That means that you eventually have to pay off the loan, typically after 10 years. This means that you get to enjoy a lower-than-normal mortgage payment for the first 10 years, and then a higher-than normal payment for the remaining 20 years. Of course, if you only plan on keeping your home for 10 years or less, the interest-only loan may be ideal for you.
If you take out an interest only mortgage, be prepared for a significantly higher payment in year 11.
2. Interest only mortgage loans may allow you to buy “too much” house. If you can only afford to pay the interest only mortgage payment, you may want to consider a mortgage that you can afford, if it were a standard 30 year payback. An interest-only loan is best for homeowners who can qualify for the fully amortized payment, but choose interest-only financing as part of a greater financial plan.
3. In a declining real estate market, interest-only loans can be a nightmare. We had a client who purchased an Arizona home for $450,000 in 2005. That same client financed his home with an interest only mortgage, in the amount of $360,000. ($450,000 minus 20% down payment or $90,000 = $360,000)
Right now, due to the decline in the real estate market, his house is worth about $350,000. He is actually upside down in his home and needs to come up with a great deal of money just to walk away.
This, of course, is an extreme example, but it is something to think about.
You have less chance of becoming “upside down” in your home if you do a conventional, principal-and-interest mortgage loan in stagnant or declining markets.