Interest Only Mortgage Basics
An interest only mortgage is a loan where the borrower pays only the interest on the principal balance for a portion of the term or the interest only period, with both the principal and interest payments still changing during that interest only period. With an interest only mortgage, the lender will calculate the amount of interest to be paid over the term of the loan based on the balance left on the original mortgage at the end of the interest only term. The only way to qualify for an interest only mortgage is to own a home that is worth at least a certain amount, usually more than the outstanding balance of the loan. Interest only mortgages are good for homeowners who need a temporary boost in their income during a time when they are temporarily unemployed, or who need to get out of debt while their income from other sources fluctuates. Interest only mortgages are also good for borrowers who need to keep their monthly payment to a minimum, for example to avoid defaulting on a loan. They can build equity in their home, thus shielding it from foreclosure, while still paying a small interest rate.
The interest only mortgage offers borrowers a way to protect their principal loans, yet make lower monthly payments over the life of the loan. By locking in the interest only portion of the principal loan, borrowers can choose to make smaller payments over the life of the loan. When the borrowers pay off the interest only mortgage, they owe nothing but the remaining principal. While this may seem like a bad idea in the long run, it allows the borrower to benefit from the interest only portion of their loan and live comfortably for the duration of the loan. If the interest only mortgage is repaid early, however, the borrower will pay the full amount of principal on a monthly basis, even if they never miss a single payment.
Due to the unstable housing prices and recession, many homeowners are unable to pay their interest only mortgages. Unfortunately, these same homeowners would be wise to purchase fixed rate mortgages instead of interest only ones. Fixed rate mortgages are backed by the Federal Reserve, which works to keep interest rates at appropriate levels. These mortgages also offer flexibility, as they are designed to provide the borrower with some measure of protection from any fluctuating interest rates. This is good news for homeowners who need additional housing investments, but can’t afford to lose the security of their fixed rate loan balance.
The primary drawback to interest-only mortgages is that they require the borrowers to maintain extremely low credit scores. These loans also come with significantly higher monthly payments than standard adjustable rate mortgages. In fact, the interest only mortgage is actually a type of refinancing. Borrowers must refinance after a ten years period in which they have paid on their principal loan balance.
During the initial interest only period, homeowners may not see any change in their mortgage payments. During this time, their payment amount may remain the same. Over the course of the interest only period, however, the monthly payments will go up dramatically. It is during this time that borrowers are able to make an offer on their primary residence. Although housing prices are falling in most areas, there are still affordable homes being sold. If you purchase a home during this time period, you can expect your monthly payments to remain relatively the same or even decrease slightly.
In order to get out of the interest only period, borrowers must begin making payments. However, the lower payments can often entice borrowers to continue to stay within the home. Once the interest rates begin to increase, however, borrowers will find that their monthly payments are much higher than they were during the interest only period. It is at this point, if they decide to refinance, that they will be required to pay the full amount of their principal back. Refinancing is usually the best option at this point, as it allows the borrower to get out of debt and purchase a home that is currently priced below its fair market value.
Homeowners that choose not to refinance are required to start making payments again immediately. This is because the new loan balance is higher than what the original loan balance was. When the balances are equal, borrowers can expect their interest rates to begin to slowly decrease until they are once again in a better position financially. It is at this point, when interest rates are at their lowest, that refinancing is the best choice, as it allows the borrower to keep monthly payments at a constant rate until they can find a better deal.
Interest only mortgages are not the only type of mortgage available to borrowers. Fixed-rate mortgages are another option available to those looking for the convenience of a mortgage loan. With a fixed-rate mortgage, the interest rate never changes, so borrowers do not have to worry about keeping up with changing interest rates. Some homeowners mistakenly believe that by taking advantage of an interest only mortgage when the rates are low, they will avoid having to pay off the principle of the loan. This is simply not the case, as in the case of a fixed-rate mortgage, the principal amount is still due at the end of the loan term.