Let’s take a minute to talk about “interest only home loans.” These days very few people seem to be interested in actually paying off their mortgage. Many prospective homeowners and current homeowners alike just want to get the cheapest financing available, with the lowest payment options.
That’s usually means securing 100% financing on top of an interest-only option.
But what many homeowners may not realize is that offsetting or reducing monthly mortgage payments increases the overall interest one pays over the life of the loan, and reduces the amount of principal one will gain in the near term.
Let’s look at an interest-only home loan to highlight this point:
Loan amount: $500,000
Interest rate: 6.25%
Principal & interest payment: $3,078.59
Interest-only payment: $2,604.17
As you can see, the interest-only payment is much more attractive than the principal and interest payment, nearly $500 less each month.
If you make interest-only payments on your mortgage each month for the first ten years, you will pay substantially less than your fully-amortized payment, but gain nothing in the way of principal, otherwise known as home equity. Precious home equity…
So if you took out a mortgage with no money down, you would have zero ownership in your home unless it appreciated during that time. Meaning home prices must rise for you to gain any equity.
Interest Only Home Loans Can Adjust Higher
And once the interest-only period came to an end, your monthly mortgage payments would jump, possibly to unmanageable levels for some. First, it would increase to the fully amortized payment, and because the full mortgage balance could still be intact, you have to pay that balance in 20 years instead of 30.
Hello significantly larger mortgage payment! That is, unless you’re able to refinance or sell before that happens…
Interest-only options are almost standard on mortgages these days. They’re available on pretty much any program, from a 30-year fixed rate mortgage to a one month adjustable-rate mortgage. Even the pick-a-pay loans have an interest-only option available.
You Pay for the Interest Only Privilege
Interest only loans usually do come at a cost, about .125 to .25 to the fee, or roughly .125 to the interest rate. So instead of an interest rate of 6.25%, you might secure a rate of 6.375% with an interest-only option. The interest-only period is usually the first 5-10 years of a 30-year loan, after which the homeowner must pay the full principal and interest payment.
However, most homeowners usually just refinance once their options are reduced, and find a new, lower payment option. And then repeat the cycle. With home prices on the up and up, the idea is that you can eventually gain considerable ownership in your home without ever paying any money to the principal.
This was the main premise of the infamous option arm. But those days seem to be well behind us now.
All that said, many think interest-only loans are a complete waste of time, and that you should always pay down at least some principal each month. But that depends on what you plan to do with your home, and if you really see yourself owning the property outright at some point.
If it’s just an investment property, or a short-term fixer upper, you could argue in favor of making interest-only payments to keep costs low while leveraging the money elsewhere. But if you plan on staying in your home long-term, it is wise to pay principal and interest to gain ownership in your home.