An interest-only mortgage allows you to pay just the accrued interest on the mortgage every month rather than the interest plus part of the principal balance owed. For example, on a 30 year fixed, $250,000 mortgage at 5.0%, the normal Principal and Interest payment would be $1,342.05 per month. An interest-only loan at 5.0% on the same $250,000 mortgage would be just $1,041.67 per month, or $300.28 lower. (The difference is the Principal that does not get paid.)
The interest-only period usually lasts for the first 5 or 10 years of the loan and then you have to start reducing the principal balance. In effect, you’re trading lower payments for the first years of the mortgage for higher payments later on, unless you pay off or refinance the mortgage. In most cases, the interest-only loan is used in conjunction with an Adjustable Rate Mortgage (ARM) although the feature is also available on fixed rate mortgages.
From the early to late 2000′s, interest-only loans became wildly popular and, unfortunately, abused, as real estate prices climbed and new homebuyers looked to maximize their purchasing power. Many existing homeowners also refinanced into interest-only loans to free up monthly cash-flow for other purposes.
Since the financial and real estate crisis began in 2007, interest only loans have fallen out of favor. In fact, they were at least partially to blame for the collapse. Many borrowers who took these loans out found out they could not afford the payments when the loans converted to “fully amortizing” loans. (Fully amortizing means the monthly payments include principal to pay off the loan in full by the end of the loan’s term – 30 years in most cases.) Many of these loans had interest-only periods of only two or three years that coincided with adjustable rates of the same time period. There was a double-whammy effect: borrowers’ rates went up – a lot – AND, they had to start paying principal back. A borrower who could just afford that $1,041.67 payment, might have seen their payments change to $1,700 overnight!! Not a recipe for success as a homeowner!
Who Is an Interest Only Home Loan For?
Many personal finance advisors and gurus preach that interest-only loans should be avoided at all costs, by all borrowers. That is sound advice for the vast majority of borrowers. If you’re contemplating an interest-only loan so you can afford a more expensive home than you could with a fully amortizing loan, you’re quite possibly setting yourself up for failure. However, interest-only loans do have their place in advanced financial planning. With an “eyes wide open”, disciplined approach, they can be an effective tool. Some of the wealthiest, shrewdest clients I have worked with over the years, have used interest-only loans successfully.
Veritas Funding offers a variety of interest only home loan options, including 30-year fixed-rate mortgages and adjustable rate mortgages. Our interest-only home loan programs are offered as interest only loans for periods of either three, five, seven or ten years.