Interest-only

Will an interest-only mortgage work for your situation?

Most homebuyers are cautious about taking out a home loan, looking to find both a property and a mortgage that will be within their financial means. At the same time, they want their home to have enough space and features to meet their needs.

One way to keep your loan payments more affordable is to look for an interest-only mortgage. As the name suggests, this type of mortgage enables you to make lower payments by paying only the interest – at least for a certain amount of time. While this type of mortgage can be useful for a variety of borrowers, it also comes with a unique set of risks.

In a conventional mortgage, a buyer borrows money to pay for the home and repays this loan on an amortized schedule, usually over 30 years. Each month's payment covers the interest on the loan, but also chips away at the principal. As the principal is reduced, the amount going toward interest is gradually reduced.

You'll eventually have to pay the principal on an interest-only loan, but the schedule is structured so that you don't have to do so right away. Elizabeth Weintraub, writing for the financial site The Balance, says one typical interest-only loan takes place over 30 years, with payments limited to interest for the first five years. Buyers may also be able to get a 40-year mortgage where their payments need to cover the interest alone for the first 10 years.

The principal balance will remain unchanged until the interest-only period ends, unless a borrower opts to contribute extra money to a monthly payment to reduce it. Justin Pritchard, also writing for The Balance, says the reduced principal may also alter the interest due in a monthly payment, but this is not the case in every interest-only loan.

The biggest advantage of an interest-only payment is that it results in a lower monthly payment. The homeowner can use this extra money for home improvements, to pay off student loans, or otherwise manage their finances and invest in the property. An interest-only loan can also be more manageable for homeowners with a variable rather than fixed income.

Interest-only mortgages can allow you to buy a more expensive property than you would be able to afford with a traditional mortgage. Since the monthly payments will be lower than those you would see on a traditional mortgage, a lender can approve you for a larger loan.

Investors often take advantage of interest-only mortgages, using the money freed up by this type of loan to pay for the renovations which are often necessary in homes purchased as an investment. Keith Gumbinger, writing for the mortgage resource HSH.com, says other borrowers are interested in investing the money they would otherwise pay toward the mortgage in the stock market or other ventures.

An investor may also expect that they can turn a tidy profit by making minimal payments and selling the home before the principal payments become due. Although they haven't built up equity in the property, improvements that increase the property's value and a natural increase in home prices can allow them to sell the home for more than they purchased it for.

The lack of equity can make interest-only loans especially risky, however. A downturn in the housing market, changes in the neighborhood, and other factors can reduce home values. If you haven't been paying down the principal, you're more likely to experience negative equity – a situation where the outstanding mortgage balance is worth more than the home's fair market value.

Borrowers who still own the property when the interest-only period ends will need to prepare for higher monthly payments. You'll still need to pay off the principal balance, but will have less time to do so; as a result, your monthly payment can increase considerably.

Interest-only loans usually come with a variable interest rate instead of a fixed rate. If rates go up, a lender can also bump up the amount that is owed each month to cover the interest.

An interest-only loan will only allow you to begin building equity once the initial term of interest payments ends. By contrast, conventional mortgages let you start increasing your ownership share in the home as soon as you begin repayment.

Some buyers may get an interest-only loan with the expectation that they will improve their financial situation in the future. They might believe they can get a higher paying job, or that they will be able to eliminate their student loans or other debts by the time the principal is due. However, this attempt to predict the future can also be risky. Unexpected circumstances, such as a job loss or medical expenses, can derail your plans.

While interest-only mortgages can often be useful for people in certain circumstances, such as those with variable income or buyers who know they need to make some expensive improvements, they can also be used for the wrong reasons. The financial site NerdWallet notes how interest-only loans played a role in the collapse of the housing market prior to the Great Recession, since lenders often granted this type of loan to borrowers who were not prepared for the risks and found themselves unable to make their mortgage payments.

For this reason, it is inadvisable to get an interest-only loan for the sole purpose of being able to afford a more expensive property. Buyers considering this type of mortgage should be prepared for potentially higher payments over time and be confident that they will still be able to afford the mortgage.