An interest only mortgage loan is a loan that you only pay interest on until the interest only period is over – usually in five or 10 years. Because you just pay interest charges every month, the payments are lower than a regular amortizing loan. All interest only mortgage loans eventually convert to a regular amortizing loan with higher payments after the interest only period ends. Interest only loans are still available with higher down payments, typically 25%.
Why Get an Interest Only Loan?
Interest only mortgages are appealing in some circumstances because they payment is lower.
Below are some common reasons that people get interest only home loans:
- Buy a bigger house. You can buy more house with a loan you only are paying interest on. Lenders determine how much you can afford to borrow based upon your monthly income and your debt to income ratio. If you have lower payments with an interest only loan, you should be able to borrow more money. If you are very confident that you can afford a more expensive home and will be able to afford higher payments later, this can be a good choice.
- Frees up funds. Lower monthly payments mean you choose where to put your money. If you like, you can put that money towards the principal on the loan. Or you can put that money into a real estate investment or mutual fund. The nice thing about interest only is that you have the option of paying more but are not required by the contract to do so.
- Keeps your costs down. There are times when an interest only loan is the only way you can afford the home right now. Interest only loans can be an option to paying rent, knowing that you will eventually be paying off principal.
- More interest to write off on taxes. You can generally write off mortgage interest on your home on your taxes. Paying more interest means more write offs. But this is now limited to mortgage debt of $750,000 and less, according to new tax laws in 2018.
- No mortgage insurance. You do not generally need PMI on these home loans as they require higher down payments.
Considerations and Downsides
It is key for you to really understand the benefits of interest only and not the temptations. Interest only loans only will work if you are using them responsibly. Remember, an interest only loan is only temporary. The time will come when you will need to start paying principal, and then the payment will jump substantially.
For instance, if you have irregular, commission-based income (think of a real estate agent), you can keep the minimum payment on your home very low when you have no or less income. But when you get a big commission, you can overpay on the mortgage and pay off a chunk of principal. This is a perfectly responsible way to use an interest only home loan. But you need to have discipline to pull it off.
In some cases, making a big payment against principal can get you a lower minimum payment in later months, but you should check with your lender as this can vary.
Here are some other factors to consider about interest only loans:
- You are not building equity. You do not get any equity in the property with this loan. You can build your equity if you make extra payments, but it is very easy to just make the minimum payment and not put more money into the home.
- You risk going underwater. Paying down the loan balance over the years has many upsides. It is especially useful when it comes time to sell the home. If by the off chance your property value has declined, it is possible to owe more than the home is worth. If that happens, you have to write a huge check just to sell. If you are not paying down the loan for years, you are at a higher risk of getting into this situation if property values drop. This is exactly what happened in the last downturn to millions of home owners. When home values tanked, many were underwater on their loans and could not sell. Many defaulted.
- Putting it off. You will eventually need to pay off the loan. Taking an interest only loan only delays this. Many ‘think’ they will be making more money in XX years, but who knows? You may be better off settling for less home today and getting a regular home loan that amortizes.
The takeaway is interest only home loans are not all bad. There are legitimate reasons for them. The problem is that you need to stick to your plan and use the extra money you are saving each month for a legitimate purpose and make extra payments on principal when you can.