Interest only home mortgage loans have made big news as contributing to the nation's housing value downturn. Many took out these loans and later couldn't afford the payments. Despite the negative press, these loans are still an attractive option for some homebuyers. However, you do need to fully understand an interest only loan and how it will affect your finances long term before considering this option when buying a house.
How it Works
With an interest only mortgage, you make payments each month to cover only the interest portion of the mortgage for a set amount of time. Typically, these interest only mortgage payments have a fixed rate and payment for the first one, three, five, or ten years of the loan. Once this initial fixed period is over, your loan resets to have you pay the interest plus principal for the remainder of the loan's life.
The initial interest only payments are temptingly low; making you believe you can afford a larger and more expensive house. However, you need to know that these low payments are temporary. Depending on how long you have the interest only mortgage payments locked in for (1 to 10 years) is how long you will be paying the low monthly payment. Once your mortgage resets, those payments will go up and probably never be that low again. This is because you will now be paying the principal and interest.
Your Principal Will Not Go Down
While you are paying only the interest on a mortgage loan, your principal, the original amount of the loan, will not go down. Consider the following if you have a 30-year mortgage loan that allows you to only pay the interest for the first 10 years. After 10 years, you will have just 20 years to pay the principal. That can make your monthly mortgage payment increase by hundreds, even thousands of dollars a month in 10 years.
Your Interest Rate May Adjust
Many interest only mortgages have a fixed interest rate for a set amount of time then switches to an adjustable rate mortgage. Once your mortgage resets to paying the interest plus principal, your rate may also adjust every 6 to 12 months. The rates are tied to the current mortgage interest rates. Although adjustable rates are typically lower than the interest rates for a standard 30 year mortgage, you adjustable rate can rise with each adjustment. This means your monthly payment can increase every 6 to 12 months.
You Can Refinance
Just as with any mortgage, you do have the option to refinance into a standard fixed rate mortgage loan. Your ability to do this may depend on the terms of your loan, there may be a balloon payment or prepayment penalty, and how much equity you have in your home. You can contact any mortgage lender or broker to find out what refinancing options are available to you.
You Can Pay More Each Month
If you apply extra money to your mortgage payment each month, it will be applied to the principal loan amount. So during your interest only period, you can still pay down your principal. This will help you pay off your mortgage sooner and may help keep the payments lower than what they would have been without the extra payments once the mortgage resets to paying the interest and principal.
Don't be lured into buying a home you really can't afford by the appeal of the low monthly payments of an interest only home mortgage loan. There are some good reasons to consider these mortgages. If you are confident that your income will increase over the next few years, if you want to put the extra cash into other investments, or plan to put extra each month to the principal, then an interest only loan may be right for you. But if you are simply taking the interest only mortgage because you could not afford the house otherwise, then you are taking a huge risk that you will not be able to make the payments when the loan resets to include the interest and principal.