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What is an interest-only mortgage?
Interest-only mortgages allow borrowers to pay only on the loan interest at the beginning of their 30-year term, typically for seven to ten years. After this implementation period ends, the borrower will pay the principal and profits for the remainder of the loan period.
How do interest-only mortgages work?
Interest will only be paid at fixed or adjustable rates during the implementation period. Since your payments don’t include principal, they will probably be much lower than you would find on a traditional loan – but the interest rates are comparable.
At the end of the first period, you will need to repay the principal with a remaining period of your term, one balloon payment on a certain date, or a larger monthly payment that includes both the principal and interest. Additionally, principal payments are amortized over 20 years rather than 30 years, so these payments are higher than those who have received a traditional 30-year loan.
You can refinance once the interest-only period has passed, but just like refinancing, you will need to pay the home assessment, closure fees and fees.
Examples of interest-only mortgages
Get a 30-year interest-only loan for $350,000, get an initial rate of 6.5% and an interest-only term for seven years. During the interest-only period, you will pay around $1,896 per month.
After this early stage, payments will rise to around $2,610 per month. Assume that the rate does not change. Many interest-only loans are converted into adjustable interest rate loans, so if your fees rise in the future, you will also pay. If you need to pay balloons instead on an interest-only loan, you’ll get a hook for hundreds of thousands of dollars.
Using a 30-year fixed-rate mortgage for the same amount will mean you will be paying $2,212 per month, including principal and interest.
The history of mortgages only with interest
In the early 2000s, many home buyers undertaked interest-only mortgages, but found that they could not afford large payments after the introduction period. This was one of the dangerous practices that contributed to the housing crisis in 2007, leading to the Great Recession. In the end, many people lost their homes.
Some lenders still offer interest-only mortgages today, but have more stringent eligibility requirements. They are currently considered ineligible mortgages or non-QM loans. Because they don’t meet the standards of assistance from Fannie Mae, Freddie Mac or other government agencies that guarantee and buy back mortgages. Simply put, interest-only mortgages are risky products.
How to qualify for an interest-only mortgage
To be approved for an interest-only mortgage, you must qualify properly. Banks generally look for borrowers such as:
- Credit scores over 700
- Debt income (DTI) ratio below 43%
- 20% or more down payment
- Strong evidence of future revenue potential
- Adequate assets
Pros and cons of interest-only mortgages
Interest-only loans can be a cautious personal finance strategy under certain circumstances, but it’s not a good idea for everyone.
Interested mortgage professionals
- Interest-only payments are less than traditional mortgage payments. The first monthly payments on interest-only loans tend to be significantly lower than traditional loan payments, and interest rates may be fixed in the first part of the loan.
- You can benefit from low prices after the introduction period. If your rates drop in the future, you can benefit from a relatively low payment once the introductory period is over.
- You may be able to afford a higher payment in the future. If you expect your income to increase, you could buy a big home now and postpone your principal payment until it fits your budget. Additionally, if you move during the introductory period, you may be able to avoid paying your principal completely.
Cons of interest-only mortgages
- You don’t build home equity. As long as you pay only interest, you are not building equality in your home. And if the value of your home drops, you could either turn upside down on your mortgage or risk negative amortization.
- You may pay an affordable price after an interest-only period. Payments may increase after the introduction period and may not be able to manage based on your income.
- You are at the mercy of market interest rates. If the fees rise after the loan is incurred, you may have a much higher payment than expected once the intro period has ended.
Should I consider an interest-only mortgage?
The best candidates for interest-only mortgages are borrowers who are confident they can cover higher monthly payments when they arise. This type of mortgage may be suitable for you:
- I’m in graduate school and want to keep my repayments low for now, but I hope to get a good pay job in the future.
- Have confidence to start releasing assets on a future date
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You need to turn the house over and keep costs down while remodeling
- Expect to move before the end of the introductory period
Interest-only mortgage alternatives
If you like some of the interest-only mortgage features and don’t think it’s for you, you can explore other types of mortgages, such as:
- Adjustable mortgage: Like interest-only loans, these mortgages tend to reduce monthly payments during the introductory period. In this case, it is due to a low initial rate and may increase or decrease over time based on market movements. Payments include principal, allowing you to build fairness even at the beginning of the loan.
- Federal Housing Administration (FHA) loans: These government-supported loans are targeted to borrowers who are not eligible for traditional loans and are able to offer monthly payments without the risk of future increases.
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Additional Reports by Kacie Goff
