The concept of interest-only mortgages has emerged not so long a go, but it is becoming increasingly popular as a method of financing homes.
When you take out a mortgage, your payment includes two parts: interest and principal, the former being the actual cost of your house and the latter being the extra amount you pay on top of that cost in order to take out a loan and is based on the interest rate your lender imposes. Thus, the interest may be considered as the price of taking out a loan.
A mortgage is called “interest-only” if the scheduled monthly mortgage payment – the payment the borrower is required to make – consists of interest only. The concept is that you will pay the interest and the principal on the basis of a special repayment schedule, in which at the beginning of the repayment period most of your payment will be interest and towards the end of it most of your payment will be principal. The option to pay only interest is usually provided at the beginning of the repayment period and lasts for a specified period, which is usually 5 to 10 years. However, even during this period a borrower, if he wants to, has a right to pay more than interest. Once the interest-only period is over, the mortgage will be re-amortized to include the principal.
The point in such scheme is that for the first several years your monthly mortgage payment will be much less then it would be with a usual mortgage. For example, if a 30-year loan of $100,000 at 6.25% is interest-only, the monthly payment will be $520.83, while a borrower with the same mortgage but without an interest-only option would have to pay $615.72. But once your interest-only period is over, your monthly mortgage payment will be higher for the remainder of your repayment period.
This option may be good for people with fluctuating incomes, as when their finances are tight, they can make interest-only payments, and when they are flush, they can make a substantial principal payment. This is also a good option for people who are short on money at the moment, but expect to get more money in the near future via a raise or investments.
And now for the drawbacks. An interest-only mortgage can be a game of chance. As for the people with fluctuating incomes, they should ask themselves, whether they are disciplined enough to make principal payments when they are not obliged to do so. As for those short on money at the moment, they should consider the risk that the expected income raise won’t materialize. In both cases you may end up being unable to pay high monthly mortgage payments after the interest-only period is over. The decision on taking an interest-only mortgage basically comes down to whether you need to save some money at the beginning of your repayment period and whether you are ready to deal with the possible consequences described above. So think twice!