Interest-only mortgages have become more popular as housing costs have skyrocketed. Because homeowners repay only the interest portion of their loan, interest-only mortgages allow smaller payments in the early stage of the repayment schedule. This comes in handy for homeowners whose income has dropped, but is expected to rebound in the future.
While the terms of interest-only loans offer buyers great flexibility, it’s important to understand that much higher mortgage payments will kick in at some point. With most interest-only mortgages, the period of lower payments lasts between five and 10 years. After that, you typically have 20 to 25 years to pay back the principal and the rest of the interest.
Buyers also need to understand they are not building equity in their homes during the interest-only period of repayment. That means they cannot use their home as collateral to obtain a low-interest home equity loan or line of credit.
It’s also important to understand the implications of a slowdown in the housing market for an interest-only mortgage. Because you have not paid down any of your principal, any drop in the value of your home could leave you owing more money than you are able to recoup through the sales price.
Many lenders advise refinancing an interest-only mortgage with a traditional fixed-rate mortgage before the interest-only period expires and you begin repaying the loan on an accelerated schedule. The sooner you do this, the smaller your payments are likely to be, because you will immediately begin repaying some of the principal.
If you aren’t able to afford the higher payments once the interest-only period expires – or refinance before that point – you could lose your home. Be sure to understand your options before you sign.