Are Interest-Only Mortgages for You?

Posted on 30. Sep, 2005 by in Credit & Debt, Real Estate

The hottest craze out there, and the one that Alan Greenspan and the rest of the Fed has begun to target, is the prolific use of interest-only mortgages. As the name suggests, these mortgages differ from traditional 30-year mortgages due to the fact that for the first 5 years or so you are only required to pay the interest. For example, if you’re getting an interest-only mortgage of $400,000 with an interest rate of 6%, you’ll pay about $1,947 a month. The largest benefit from this type of financing, and the one that has attracted so many people, is that by paying only the interest your mortgage payments are lower and you are more likely to get into your dream home faster. Should you try the interest-only mortgage then? It depends on your situation and if your goal is to pay as little as possible up front. However, there is one problem with the interest-only option:

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If you had gotten a traditional 30-year mortgage to begin with you would be paying a steady $2,357 each month. So for the first 5 years the interest-only option would be saving you some money. However, at the end of the 5 years the interest-only mortgage becomes a 25-year traditional mortgage at 6% which makes your payments $2,538 a month. So after five years your payments become more than they would be with a traditional mortgage. In this situation you could either pay that amount, or you could try and refinance; however, if interest rates increased even 1% then you could be paying $2,772 a month. So unless the interest rate drops after you buy your house then after 5 years your mortgage payments are likely to increase – regardless of whether you keep your current traditional mortgage or decide to refinance.

The bottom line is: if you are willing to bear the risk of interest rates going up then an interest-only mortgage may be for you. Otherwise, stick to a more traditional option.

2 Responses to “Are Interest-Only Mortgages for You?”

  1. Bruce Smeaton

    01. Apr, 2007

    As an ex-banker from Auckland, New Zealand, I concur with your views wholeheartedly. Unfortunately, many unscrupulous mortgage lenders and brokers have ‘pushed’ marginal clients into taking interest only mortgages just so they (the clients) would qualify on debt-servicing!

    In reality, many of these so-called marginal clients wouldn’t have qualified for a normal P&I (Principal & Interest) loan because, with the inclusion of principal in the repayments, the end result would’ve been “negative monthly surplus!”

    One excellent use of an interest only loan however, is in a situation where you are taking a mortgage against an investment property and are looking to preserve your cashflow. You’re only paying the interest applicable to the loan (for up to five years) and not the actual principal of the loan itself.

    In New Zealand, a property investor can “roll over” his or her interest only loan every time they come up for renewal i.e. if you took out a 3 year interest only loan today, then in exactly 3 years time you could renew it for another fixed term period, also on an interest only basis. This would be on the proviso that any other loan payments (such as the mortgage – if you have one – applicable to your family home) had been managed in a manner “satisfactory to the bank” during the initial fixed term period.

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    […] Beancounterblog.com has a good take on interest only mortgages and gives a good overview of this type of mortgage product. […]

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