What Is an Interest Only Mortgage Loan?

Mortgage

What Is an Interest Only Mortgage Loan?

If you are considering purchasing a home then you may be looking at the different options available for mortgages. One option that you might consider is an interest only mortgage loan. This type of loan is just what the name suggests, one in which you pay interest only and you aren't paying any money of the actual principal of the loan. Your full monthly payment is only paid on the interest although this is only for a certain period and at some point the loan will change to interest and principal.

When you first take out an interest only mortgage loan it is set up so the payments are interest only for a certain number of years. When those years are up the loan is then changed to a loan in which the payments will begin to come off the principal balance.

Interest only mortgage loans are usually set up this way for five to ten years of the loan and then when that time is up the loan will change. The reason that many people choose this type of loan is so that they can make smaller payments for those five or ten years. Because they are paying interest only and not paying any money against the principal then the monthly repayment is lower than a traditional interest and principal loan.

If you are going to live in the home you are buying and you know that your income is going to increase then an interest only mortgage loan might be a good option due to the lower payment which will reduce your income to debt ratio. If you are purchasing a home as an investment property then an interest only mortgage is also a good option as it will allow you to have more cash flow that you can use in the event of any repairs or improvements needed on the home.

Although there are advantages to an interest only mortgage loan there are also some disadvantages. The biggest disadvantage to this type of loan is that it is quite risky for the borrower. When a buyer takes out a principal and interest loan they are beginning to build equity in the home right from the start. With an interest only mortgage you will not be building any equity whatsoever. You will only build equity in the home when you begin making payments off the principal and because you don't do that with an interest only loan you will not be building any equity.

The problem with not building any equity in the home is that when the interest only period ends you may find that you can't afford the higher payments that the loan changes to. The payments will be higher than a traditional loan because you have spent those years with interest only and now have a shorter period of time to pay off the principal. This is why you should only have an interest only loan if you believe your income will increase so you can afford those payments when they increase.

There is that big risk that once you have to start paying interest and principal you will not be able to afford those payments. If it reaches a point that you can't afford the repayments you may need to sell the house, but if it isn't a buyer's market at the time then you may have trouble doing that. You will not be able to refinance the loan either as refinanced loans are only given as a result of equity in the home - and you will have no equity so you would not be eligible for refinancing. You could find yourself in a very difficult situation that could be avoided if you started paying both interest and principal right from the start.

Mortgage

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