What Is an Interest-Only Mortgage?
An interest-only mortgage is a unique type of home loan where the borrower is obligated to make only interest payments for a specific period, deferring the repayment of the principal amount until later. This can involve paying off the principal as a lump sum at a designated time or through subsequent payments.
### Key Takeaways
– An interest-only mortgage allows you to make interest payments only for the initial years of the loan, different from traditional mortgages.
– The interest-only period can vary in duration, offering flexibility and potentially lower initial payments.
– Typically, interest-only mortgages are structured as adjustable-rate mortgages (ARMs), with payments gradually transitioning to include both principal and interest.
Understanding an Interest-Only Mortgage
Interest-only mortgages come in various forms, with options for different payment structures. Borrowers may opt to exclusively pay interest for a set period or throughout the loan term. However, some lenders may limit this provision to specific borrower profiles.
Most interest-only mortgages require solely interest payments for a fixed period, typically five, seven, or ten years. Subsequently, the loan shifts to a fully-amortized schedule, requiring payments towards both interest and principal.
These loans are often structured as interest-only adjustable-rate mortgages (ARMs), where a set introductory period involves paying only the interest. Following this period, repayments encompass both principal and interest, with adjustable interest rates kicking in.
Fixed-rate interest-only mortgages are less common and are usually associated with longer mortgage terms, such as 30 years.
Paying Off the Interest-Only Mortgage
Upon the expiration of the interest-only period, borrowers have multiple options. They may consider refinancing the loan, selling the mortgaged property, or making a lump sum payment to settle the principal debt.
Special Considerations for Interest-Only Mortgages
Certain interest-only mortgages offer provisions for scenarios where borrowers may solely pay the interest component, like in cases of property damage necessitating high maintenance costs. It’s crucial for borrowers to plan for potential lump sum payments required at the loan term.
Interest-Only Mortgage Advantages and Disadvantages
Interest-only mortgages provide borrowers with lower initial monthly payments as only interest is required. This offers increased cash flow and flexibility for managing expenses, catering even to first-time home buyers delaying substantial payments to later years when income is expected to rise.
However, by not contributing to the principal, borrowers do not accumulate equity. Transitioning to payments including principal can lead to significantly higher monthly payments, posing challenges during financial downturns like job loss or unexpected emergencies.
Borrowers need to evaluate future cash flow carefully to meet increased obligations and settle the loan appropriately. While interest-only mortgages offer benefits, they also carry default risks necessitating prudent financial planning.