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Types of Mortgages: Interest Only

By Edited Apr 30, 2015 0 0

Interest-only mortgages have been around for some time, but enjoyed quite a bit of popularity in the last decade or so. What exactly is an interest-only mortgage, and why would a borrower choose this type of mortgage loan?

An interest-only mortgage, just as the name implies, is one where the borrower pays only interest on the principal amount of the loan to the mortgage company for a set amount of time. Lending institutions can, and do, provide interest-only mortgages in a great number of configurations, so it is easy to find an interest-only loan to fit almost any circumstance.

Many interest-only mortgages are hybrids, meaning the borrower pays interest on the principal for a specific amount of time and then the loan amortizes for its remainder. For example, the full term of the mortgage may be thirty years, with interest-only payments for the first ten years. In this situation the borrower will make interest-only payments for those first ten years, without paying down any of the principal balance. After those ten years though, the loan will amortize and the borrower will need to pay both interest and principal for the remaining twenty years, until the entire amount—interest and principal—are paid off in full. While this is the most common organization of interest-only loans, there are more unique setups out there. For instance, there are interest-only loans where the borrower pays only interest for the entire term of the loan—sometimes up to thirty years—and then must pay the entire principal amount in one final balloon-style payment. In virtually all interest-only situations borrowers have the opportunity to pay extra, which pays down their principal amount, at all times. Such a pay-down of the principal then readjusts the next month’s payment amount—usually to a lesser sum—because the principal is lower and the lending institution charges the interest rate based on the principal amount. The largest benefit then, obviously, is the flexibility interest-only mortgages provide to homebuyers.

The increased flexibility of the interest-only loan takes the most common form of flexible monthly payments. As an interest-only payment is substantially less than an amortized payment, those with this type of mortgage begin with the benefit of a substantially lower payment. Add on top of this the ability to pay down principal and the chance to substantially lower their minimum interest payment each month is an even bigger advantage. The ability to go back down to the minimum interest-only payment amount when necessary is perhaps the largest benefit of all to this type of mortgage. For those in sales and whose income depends on commission, as well as others with likewise fluctuating income, this type of monthly payment flexibility is absolutely necessary in order to make a mortgage payment; otherwise, such individuals might never have the opportunity to own their own home. Besides monthly payment flexibility, interest-only mortgages allow borrowers to contribute more of their income to investment vehicles and other retirement products.

By substantially reducing a borrower’s monthly mortgage payment, an interest-only mortgage frees up a larger portion of the borrower’s monthly income which they can then invest in a more profitable investment vehicle than their mortgage. For instance, many individuals with interest-only mortgages take the extra money they save from their lower mortgage payment and contribute further to their 401(k)s, invest in other forms of real estate, build up their children’s college funds faster, and otherwise make better use of their money. This is especially beneficial because by investing the saved money in more profitable financial vehicles mortgagors can use their larger returns to pay off their mortgage in full when it is due or even before, they can build a more comfortable retirement for themselves, or earn additional income through the purchase of a rental property. Whatever they choose to do with the money, the main point is that they are putting those funds to much better use than by simply paying off an amortized mortgage loan.

It is true that at first glance an interest-only mortgage appears to be almost counter-intuitive to mortgagors. However, upon closer scrutiny, choosing an interest-only mortgage is in many ways the smartest way to own a home and make a borrower’s money work as hard as possible for them. Rather than just paying down a mortgage and having little, indeed if any, money left over to invest, borrowers with an interest-only mortgage have many more investment options. Because of the flexibility of these mortgages, lenders have more payment term flexibility as well, allowing more borrowers the opportunity to purchase their own home, a chance they might otherwise not have had. There are many borrowers that can benefit from an interest-only mortgage, and by learning as much as possible about them, potential homebuyers truly do give themselves the chance to not only purchase a home, but truly make a worthwhile investment for themselves.

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