Mortgagerateslocal.com – Are you looking for a way to lower your monthly mortgage payments and free up some cash for other purposes? Do you want to buy a more expensive home than you can afford with a traditional mortgage? If you answered yes to any of these questions, you might be interested in an interest only mortgage.
An interest only mortgage is a type of mortgage where your monthly payments will be much lower than with a regular mortgage. After that, you have to pay back the principal amount you borrowed, either in a lump sum or in regular payments.
An interest-only mortgage can help you save money in the short term, but it also has some drawbacks. You will not build any equity in your home, and you will face a higher payment when the interest-only period ends. You will also need to have a clear plan on how to repay the loan at the end of the term.
An interest-only mortgage is not for everyone, but it can be a good option for some borrowers who have a stable income, a large deposit, and an approved repayment vehicle. We will explain how an interest-only mortgage works, what are its pros and cons, and how to compare it with other mortgage options. Let’s get started!
What is an interest only mortgage?
An interest only mortgage is a type of mortgage where you only pay the interest on the loan for a certain period, usually the first 5, 7, or 10 years. After that, the loan converts to a standard mortgage, where you start paying both the interest and the principal. The interest rate may also change from a fixed rate to an adjustable rate, depending on the type of loan you choose.
For example, let’s say you borrow $200,000 with an interest only mortgage at a fixed rate of 3% for 10 years. Your monthly payment for the first 10 years will be $500, which is only the interest on the loan. After 10 years, the loan converts to a 20-year standard mortgage at an adjustable rate of 4%.
Your monthly payment will jump to $1,212, which includes both the interest and the principal. You will also owe the original amount of $200,000 at the end of the term, unless you make extra payments or refinance the loan.
What are the pros and cons of an interest only mortgage?
An interest only mortgage has some advantages and disadvantages that you need to weigh carefully before you apply for one. Here are some of the main pros and cons:
Pros
- Lower monthly payments: The main benefit of an interest only mortgage is that you can enjoy lower monthly payments for the first several years of the loan. This can help you save money, improve your cash flow, or invest in other opportunities. It can also help you qualify for a larger loan amount or a more expensive home than you can afford with a regular mortgage.
- Flexibility: Another benefit of an interest only mortgage is that you have more flexibility in how you manage your finances. You can choose to make extra payments towards the principal whenever you have extra money, or you can use the money for other purposes. You can also refinance the loan at any time, or sell the home before the interest only period ends, if you want to avoid the higher payments later on.
- Tax benefits: Depending on your tax situation, you may be able to deduct the interest payments on your interest only mortgage from your taxable income. This can reduce your tax liability and increase your net income. However, you should consult a tax professional to determine the exact tax implications of an interest only mortgage for your case.
Cons
- Higher total cost: The main drawback of an interest only mortgage is that you will end up paying more interest over the life of the loan than with a regular mortgage. This is because you are not reducing the principal balance for the first several years of the loan, and you are paying interest on a larger amount. You will also face higher payments after the interest only period ends, which can be a shock to your budget and may cause financial stress.
- No equity build-up: Another drawback of an interest only mortgage is that you are not building any equity in your home for the first several years of the loan. Equity is the difference between the value of your home and the amount you owe on the mortgage. Equity can increase your net worth, provide a cushion in case of financial emergencies, or allow you to access funds through a home equity loan or line of credit. With an interest only mortgage, you are essentially renting your home from the lender, and you may not benefit from any appreciation in the home value.
- Risk of negative equity: A related risk of an interest only mortgage is that you may end up owing more than your home is worth, especially if the home value declines or the interest rate increases. This is called negative equity or being underwater on your mortgage. Negative equity can make it difficult or impossible to refinance or sell your home, and you may lose your home to foreclosure if you default on the loan.
How to compare an interest only mortgage with other options?
An interest only mortgage is not the only option available for borrowers who want to lower their monthly payments or buy a more expensive home. There are other types of mortgages that may suit your needs better, depending on your goals, preferences, and financial situation. Here are some of the most common alternatives to an interest only mortgage:
- Adjustable-rate mortgage (ARM): An adjustable-rate mortgage is a type of mortgage where the interest rate changes periodically, usually based on an index and a margin. The initial rate is usually lower than the market rate, which means lower monthly payments for the first few years of the loan. However, the rate can increase or decrease after the initial period, which means higher or lower payments later on. An ARM can be a good option if you plan to sell or refinance the home before the rate adjusts, or if you expect your income to increase in the future. However, an ARM can also be risky if the rate increases significantly and you cannot afford the higher payments or refinance the loan.
- Balloon mortgage: A balloon mortgage is a type of mortgage where you pay a low fixed rate for a certain period, usually 5 or 7 years, and then you have to pay the entire balance of the loan in one lump sum at the end of the term. This means very low monthly payments for the first few years of the loan, but a very large payment at the end. A balloon mortgage can be a good option if you have a large amount of cash available at the end of the term, or if you plan to sell or refinance the home before the balloon payment is due. However, a balloon mortgage can also be very risky if you cannot pay the balloon payment or refinance the loan, and you may lose your home to foreclosure.
- 40-year mortgage: A 40-year mortgage is a type of mortgage where you pay a fixed or adjustable rate for 40 years, instead of the usual 30 years. This means lower monthly payments, but also more interest over the life of the loan. A 40-year mortgage can be a good option if you want to reduce your monthly payments and have a stable income for the long term. However, a 40-year mortgage can also be more expensive and less flexible than a shorter-term mortgage, and you may not build equity as fast.
To compare an interest only mortgage with other options, you can use a calculator to estimate your payments, costs, and savings under different scenarios. You can also consult a mortgage broker or lender to get personalized quotes and advice. Here are some factors to consider when comparing different types of mortgages:
- Monthly payment: This is the amount you pay each month towards your mortgage. It includes the interest and the principal (if applicable). You should compare the monthly payment for the entire term of the loan, not just the initial period. You should also factor in other costs, such as taxes, insurance, fees, and maintenance.
- Total cost: This is the total amount of interest and fees you pay over the life of the loan. It does not include the principal, which you have to repay anyway. You should compare the total cost for the entire term of the loan, not just the initial period. You should also factor in the opportunity cost of not investing or saving the money elsewhere.
- Equity build-up: This is the amount of equity you accumulate in your home over time. Equity is the difference between the value of your home and the amount you owe on the mortgage. Equity can increase your net worth, provide a cushion in case of financial emergencies, or allow you to access funds through a home equity loan or line of credit. You should compare the equity build-up for the entire term of the loan, not just the initial period. You should also factor in the potential appreciation or depreciation of the home value.
- Risk: This is the likelihood and impact of negative outcomes that may affect your mortgage or your home. These include interest rate changes, home value changes, income changes, payment changes, balloon payments, negative equity, foreclosure, etc. You should compare the risk for the entire term of the loan, not just the initial period. You should also factor in your risk tolerance and contingency plans.
How to apply for an interest only mortgage?
If you have decided that an interest only mortgage is the best option for you, you need to follow some steps to apply for one. Here are some of the main steps:
- Check your credit score: Your credit score is a measure of your creditworthiness and financial history. It affects your eligibility and interest rate for an interest only mortgage. You should check your credit score before you apply for a loan, and try to improve it if it is low. You can get a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian, and TransUnion) once a year at [AnnualCreditReport.com]. You can also use a free service like [Credit Karma] to monitor your credit score and get tips on how to improve it.
- Compare lenders and rates: You should shop around and compare different lenders and rates for an interest only mortgage. You can use online tools like [Bankrate] or [LendingTree] to get quotes from multiple lenders and see what terms and conditions they offer. You should also check the reputation and reviews of the lenders you are considering, and avoid any scams or predatory practices. You should look for the lowest interest rate, the longest interest only period, the lowest fees, and the most favorable terms for your situation.
- Prepare your documents: You should prepare and gather all the documents you need to apply for an interest only mortgage. These include your personal identification, proof of income, proof of assets, bank statements, tax returns, credit reports, etc. You should also have a clear idea of how much you want to borrow, how much you can afford to pay, and what type of property you want to buy. You should also have a pre-approval letter from a lender, which shows that you are qualified for a loan and how much you can borrow.
- Submit your application: You should submit your application to the lender of your choice, along with all the required documents and fees. You should also be ready to answer any questions or provide any additional information that the lender may request. You should also be prepared to negotiate the best deal possible, and ask for any discounts or waivers that you may be eligible for. You should also review the loan estimate and the closing disclosure that the lender will provide you, and make sure you understand all the terms and costs of the loan.
- Close the deal: You should close the deal and finalize the loan with the lender, after you have inspected the property, appraised the value, and obtained the title and insurance. You should also sign all the loan documents and pay all the closing costs. You should also receive the keys to your new home and start making your interest only payments.
How to manage an interest only mortgage?
After you have obtained an interest only mortgage, you need to manage it carefully and responsibly. Here are some tips on how to do that:
- Make extra payments: One of the best ways to manage an interest only mortgage is to make extra payments towards the principal whenever you can. This will reduce the amount you owe, the interest you pay, and the payments you face after the interest only period ends. It will also help you build equity faster and avoid negative equity. You should check with your lender if there are any prepayment penalties or restrictions before you make extra payments.
- Refinance the loan: Another way to manage an interest only mortgage is to refinance the loan before or after the interest only period ends. This can help you lower your interest rate, extend your interest only period, or switch to a different type of loan that suits your needs better. However, refinancing may also involve fees, closing costs, and a new appraisal. You should compare the benefits and costs of refinancing, and make sure you can qualify for a new loan with better terms and conditions.
- Sell the home: Another way to manage an interest only mortgage is to sell the home before or after the interest only period ends. This can help you pay off the loan, avoid the higher payments, or cash out your equity. However, selling may also involve commissions, taxes, and moving costs. You should also make sure you can sell the home for more than you owe on the loan, and that you have a plan for where to live next.
Conclusion
An interest only mortgage is a type of mortgage where you only pay the interest on the loan for a certain period, usually the first 5, 7, or 10 years. This can lower your monthly payments, increase your cash flow, and help you buy a more expensive home.
However, an interest only mortgage also has some risks and drawbacks, such as higher total cost, no equity build-up, and risk of negative equity. You should compare an interest only mortgage with other options, such as adjustable-rate mortgage, balloon mortgage, or 40-year mortgage, and see which one suits your goals, preferences, and financial situation better. You should also follow some steps to apply for an interest only mortgage, and manage it carefully and responsibly.
