More and more home buyers are considering interest-only mortgages to get the most bang for their buck in the current low interest rate market. The loans are, however, double-edged financial swords.
First "interest-only" is a bit of a misnomer. It's not as if the loan is principal free. It's just that the loan's terms permit you to make monthly interest-only payments -- for a period. During that period, of course, the loan balance doesn't shrink.
I met one homeowner who had taken an interest only mortgage plan when he bought a lakefront home, it had a low 'fixed rate' and a low fixed payment -- it's just that the principle went up over time to support the low rate. It was a shock to him that he owed more than he had paid for the home and a good deal more than the place was worth, in today's market.
Mortgage expert Jack Guttentag, the "Mortgage Professor" says the interest-only period is typically 5 to 10 years and at the end of that period the loan converts and your monthly mortgage payment is raised to the fully-amortizing level. The new payment will be larger than it would have been if it had been fully-amortizing when you first signed for the loan. Otherwise at the end of the 5- to 10-year period the borrower can opt to refinance for a lower rate or sell the home and take on another mortgage.
Some interest-only loans never convert and, at the end of 30 years, demand a balloon payment for the principal balance.
You'll have to have the money for the larger payment or the balloon payment or be qualified to refinance the loan. If you can't hack it, you could suffer not only the loss of the property, but also a serious credit report ding. Also, your home may appreciate in value, but your equity gain will be zero during the interest-only period.
The biggest negative is that you never build equity. That's fine if there is appreciation, not so good in a down market, because the value of the note goes down if it has to be sold.
Why then, would you want to pay interest only?
An interest-only payment is less than a principal and interest payment. That gives you additional leverage to buy a larger home, or the same home with less money down or otherwise enjoy greater financial flexibility.
With the reduced monthly cash flow, if there is no prepayment penalty, you can pay extra to bring down the loan balance, while affording a more expensive home in the qualification process. For any period that you only pay interest you will, however, defeat one of the primary purposes of buying a home -- to gain wealth.
"When you pay down the balance of your mortgage, you are increasing your wealth by reducing debt. But so long as you have an interest only mortgage, you are not increasing your wealth in that way," says Guttentag.
"Of course, you may be increasing your wealth by accumulating assets instead. If you have such a plan and you have determined that it is more effective in building wealth during the interest only period than paying down mortgage debt, fine. But for most homeowners, paying down mortgage debt is the most effective way to build wealth, especially in today's financial environment," he added.
Overall it seems as though there may be circumstances that make an interest only loan attractive. The nagging problem with them is that consumers are overspending and this does nothing to stop them from getting in over their heads. If you are going to look into an interest only loan you should talk to a trusted financing pro, like Ed Harrigan at Simons and Leoni Home Loans.