Interest Only Mortgages: The Ins and Outs

Posted by Nick Niesen on October 29th, 2010

Buying a home, like any other big purchase, ought to be done only after one has taken all measures to ensure that they are educated, informed, and prepared. There is nothing more gut wrenching and heart breaking, not to mention just downright depressing, than committing yourself to a six-figure debt only to find out that you didn?t actually pick the best kind of debt for yourself. Now, I know that some of you, like me, were taught that debt was a bad thing. Well, that is half true. There are too kinds of debt, responsible and irresponsible. Irresponsible debt will be a topic for a future article but I think it, well, responsible, to talk about responsible debt as it pertains to the purchase of a house. The house purchase is generally considered an all around good idea. The debt is usually considered responsible across the board. There are, however, varying degrees of responsible debt even within the boundaries of the house purchase. Having said that, I would like to take a look at what an interest only mortgage is, whom it is designed for, what the rewards are, and what the long-term implications are.

What is an Interest Only Mortgage?

An interest only mortgage is almost exactly what it sounds like. There is indeed a principle amount that goes along with it and you will indeed be held responsible for the reimbursement of that principle loan. As the layman would say, if you borrow $100 and you only pay the interest for a while, you still eventually have to pay the $100 back. What an interest only mortgage does is allow you to, for a certain period of time, only pay towards the interest of the your loan. It doesn?t cut down the principle at all, at least not until the designated period is up (usually 5 years).

Who is the Interest Only Mortgage Designed For?

The interest only mortgage is designed for the homebuyer that is on a tight budget, or the homebuyer that wants to buy something that is out of their price range. I suppose that in both situations the homebuyer cannot afford the house but in one case they don?t earn enough to buy anything and in the other, they just want to be able to live outside of their means. But, nonetheless, the interest only mortgage is for both of them. This loan is also designed for people who are fairly certain that their income will be increasing within the next few years because, unlike a fixed rate loan, the payments on an interest only loan do rise.

What Are The Rewards?
There are some really great rewards to an interest only loan. Because you only are paying the interest and none of the principle, the amount of your monthly payment decreases. On an average size of, lets say $200,000, it will save you around $175-$200 per month in payments. For someone on a tight budget, that is a big difference. On a $1 million dollar loan the savings will approach $1,000 per month. The downside to it is that after the first 5 years (or whatever the term is that you have worked out for the interest only part) your payments will jump up and be higher than they constant payments on a fixed rate loan. It is definitely a nice way to get into something that you cannot afford now but are sure you will be able to afford later. It is also nice for someone who is interested in buying a house and reselling it in a few years for a profit as the money paid into it, the all around total investment, will be less.

What Are The Long Term Implications?

Speaking of the long term is where the interest only loan begins to get scary. Imagine that you take an interest only loan for $100,000 and begin making payments. Because you are paying only the interest the payment would drop from the average fixed rate payment of around $600 per month to $500 or so for the interest only loan. You continue in this manner for five years and then the remaining balance is converted into a fixed rate loan. You still have an outstanding balance of $100,000 but now you only have 25 years to pay it off instead of 30. In the end you will wind up paying $8000 to $10,000 more over a 30-year period. If, however, you do not plan on actually staying in that house for 30 years, the long term implications is not that important.

Conclusion
As I see it, if you are trying to get a house that you want to stay in until you are old enough to leave it to your grandchildren, perhaps the interest only mortgage is not the best option for you. It would be better in the long run to go with something else, something that will not cost so much in interest. But, if you are young, nomadic, or on your way up the corporate ladder, this is definitely something to consider. This type of mortgage will allow you to get into a pricier house, have a little extra money for upgrades, and then sell it in a few years for a large profit when that job promotion forces you to move to another city. It is a great way to save money in the beginning but can be a real gamble if you stick it out for the long haul. And, as always, sit down with a trained professional who knows your situation, your needs, and your desires. They will be the best assets you have when it comes to your assets!