Understanding the Benefits and Risks of Interest-Only Mortgages

Written by Posted On Tuesday, 09 July 2024 11:33

With traditional mortgages, you make monthly payments that are part interest and part principal. Interest-only mortgages let you postpone repaying the principal portion of your loan for several years — even up to a decade. While this will keep your initial payments low, you may be caught off guard when the interest-only period ends and you’re suddenly facing a higher payment each month.

How interest-only mortgages work

Interest-only mortgages let you pay only the interest portion of your mortgage for a period of time, usually between five and 10 years. This keeps payments early in your loan term low, but it also means your loan amount does not decrease during this period. Once the interest-only period ends, you'll need to begin paying off both principal and interest, which will cause your payments to increase.

After the interest-only period ends, you'll need to begin repaying the principal. You can typically do this in one of a few ways:

  • Continue making monthly payments: Your payment schedule can remain the same, but the payments will increase now that you are paying back both principal and interest.
  • Repay the full loan balance: If you have the cash available, you can pay off your entire loan. This avoids the issue of increasing monthly payments but may not be feasible depending on the size of your loan.
  • Refinance: You may be able to refinance your mortgage, but since you'll have no equity in the home, you'll have limited options. Only some lenders or refi programs are willing to refinance a home with no equity.

Any of these options can work. The key is to make sure you have a plan for how you'll handle the payments once the interest-free period ends.

The benefits of interest-only mortgages

  • Lower initial monthly payments: Since you're paying back only the interest on your mortgage in the first few years of the loan, the early payments tend to be lower than with other types of loans. This can make it easier to transition into mortgage payments and may be particularly helpful for young homeowners whose income hasn't peaked yet.
  • Increased cash flow: Having lower monthly payments in the early years can help with cash flow during this period. It'll give you some extra money that can go toward other expenses or savings.
  • Retirement savings boost: The importance of saving for retirement can't be overstated. And the earlier you begin, the greater your chance of a fruitful retirement becomes. A lower mortgage payment during the pivotal early years can help you boost your savings and build a better future for yourself.

The risks of interest-only mortgages

  • Payment shock: Once the interest-only period ends, you'll need to start paying off the principal as well as the interest.Your payments may double or triple as a result. This can cause payment shock and require adjusting your budget to compensate.
  • Interest rate fluctuations: Interest-only mortgages are usually adjustable rate mortgages, so the interest rate may change throughout the loan period. Changes can be monthly or every few years. This means your payments can fluctuate equally rapidly.
  • Not building equity: You only build equity in your home when you pay off the principal amount on the loan. As a result, you won't be building equity in your home during the interest-only period.
  • May lose equity: There's also the risk that you lose whatever equity you had from your down payment during the interest-only period if your home's value declines. This can make it harder to refinance if you decide to go that route.

Should you get an interest-only mortgage?

After reviewing the benefits and risks to interest-only mortgages, the question remains: Is this type of mortgage right for you?

An interest-only mortgage might make sense if you're willing to make larger mortgage payments in the later years of your loan in exchange for lower payments earlier. But make sure you have a strategy in mind for how you'll cover the larger payment later.

The Consumer Finance Protection Bureau (CFPB) cautions that, "if you can’t afford the higher payments on today’s income, consider another loan."

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Rob Bhatt

Rob Bhatt is a licensed insurance agent and joined the staff of Lending Tree in 2021. Previously, he spent more than 20 years writing for and editing regional publications in California, Nevada and Washington. Rob enjoys helping readers understand how different coverages work so they can make informed purchasing decisions, and he specializes in producing research-backed content for LendingTree about auto, home and renters insurance. His work has been cited by ABC, Business Insider, MSN and Yahoo.

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