Interest-Only Home Loans

Let’s take a moment to talk about interest-only home loans.  These days, very few individuals seem to be interested in actually paying off their mortgage. Many prospective 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. And with so many exotic mortgage programs available, such as negative-amortization loans and programs with introductory teaser rates, it’s easy to understand why.

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. The pick-a-pay loans have an interest-only option available as well.

Do You Want to Pay Off Your Loan or Keep Payments Low?

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 home equity one will gain.

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 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 whatsoever.

Interest-Only Home Loans Eventually Adjust Higher

Here’s another important warning about interest-only home loans.  The interest-only period typically only lasts for the first 5-10 years of the loan, at which point your monthly mortgage payments can jump to possibly unmanageable levels.

You actually get hit twice.  After the interest-only periods ends, your minimum payment converts to the fully-amortized payment.  And because the entire mortgage balance could still be intact after only paying the interest due each month, you’d have to pay that balance in 20 years instead of 30 (assuming it’s a 30-year loan).

Hello significantly larger mortgage payment!  That is, unless you’re able to refinance or sell before that happens…which is what most people bank on.

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 balance.

This was the main premise of the infamous option arm. But those days seem to be well behind us now.

You Pay for the Interest-Only Privilege

Interest-only loans usually come at a cost too, about .125 to .25 to the fee, or perhaps .125 (1/8) to the interest rate. So instead of an interest rate of 6.25%, you might be stuck with a rate of 6.375% if you opt for an interest-only option.  Or higher closing costs.

Put simply, you actually have to pay for the privilege to not pay down your principal balance, which seems a bit odd.

That being said, many think interest-only mortgages are a complete waste of time, and that you should always pay down at least some principal each month. But it really depends on what you plan to do with your home, and if you 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.

Benefits of interest-only mortgages

  • Smaller monthly mortgage payment
  • More affordable if money is tight
  • You can buy a bigger/more expensive home today
  • Excess cash each month can be used for other higher-yielding investments
  • Less money locked up in an illiquid asset
  • You can still build equity if home prices rise

Disadvantages of interest-only mortgages

  • None of the monthly payment goes toward principal
  • You typically must pay a cost or take on a higher interest rate for the IO option
  • You can land in an underwater position pretty easily
  • The interest-only period is temporary
  • You will need to refinance, sell, or make larger payments in the future
  • Harder to sell/refinance with little or no equity
  • Doesn’t really work without home price appreciation

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One Comment

  1. Tim Talman August 16, 2014 at 10:21 pm -

    Thanks for your article Colin. Boy do I wish I knew how to get my family out of the underwater, interest only, bank held property we are now carrying around like an anchor! We desperately want to get out and buy a new modestly bigger property, but are held down by our current situation.
    TT

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