Interest-Only Mortgages: What Are They and Are They a Good Option?

Near the end of July 2015, USA Today ran a story under the headline "Uh-oh: Interest-only mortgages are back." It reported that some lenders are once again offering these home loans, though mostly to people who are in very strong financial positions.

That "uh-oh" is understandable. These particular mortgages were among the worst of the 2007-08 credit crunch's bad boys, causing pain to borrowers and lenders alike. However, in some circumstances they can be beneficial to borrowers, though the added risk they almost invariably bring probably makes them best suited to those who are not susceptible to hypertension.

What Are Interest-Only Mortgages?

As the name implies, these financial products allow you to pay only interest on your home loan, leaving the "principal debt" (the amount you originally borrowed) unchanged. Clearly, lenders want that principal back at some point, but most interest-only mortgages provide an agreed initial period—often five or 10 years—during which your monthly payments cover only the interest due, and are therefore significantly lower than they would be with a traditional home loan. Once that initial period ends, you have to pay interest and reduce the principal, but you're spreading the latter over a shorter period than usual so the monthly payments should then become higher than those you'd pay with a mainstream mortgage. For example, when you normally borrow $200,000 (the principal) over 30 years, you begin to pay down the amount you owe from your very first payment. If you had a 30-year loan with a 10-year interest-only period, at the end of the first decade you'd still owe $200,000, and would have to pay that plus interest over just 20 years.

Actually, you are free to pay more than just the interest during any month, so you could owe—at the end of the first decade—as much or even less than someone with a more common loan. But, if you plan to do that, why take an interest-only loan in the first place? After all, historically, more people default on interest-only products than others, so they pretty much invariably come with higher mortgage rates. Typically, you need to add between 3 percentage points and 5 percentage points to the rate you've been quoted for a mainstream loan. If you'd normally be offered 4.0 percent, expect to pay 4.3 percent or 4.5 percent for an interest-only mortgage.

When Are Interest-Only Mortgages Good?

Generally speaking, there are five main circumstances in which these interest-only mortgages can benefit consumers:

  1. When the borrower can be certain his or her financial circumstances are going to improve dramatically. Suppose you've just graduated from a prestigious law or medical school, and your earning capacity is about to go through the roof. An interest-only loan might allow you to buy an appropriate home now rather than face the hassle and expense of upsizing from a smaller place in a few years' time. This can be especially attractive to first-time buyers.
  2. When home prices are set to rise sharply in the long term. With lower monthly payments, you can buy a more expensive home (and therefore stand to make more money as your property appreciates) than if you choose a mainstream loan. And, when the initial interest-only period ends, you should find it easy to refinance on the back of the money you've acquired through your home's increased value. Many of those who adopted this strategy before the credit crunch discovered to their costs that it's impossible to be absolutely sure that home prices are going to go up in the long term.
  3. When you rely on commissions or are a freelancer/consultant. The variations in your monthly income may sometimes make it impossible for you to meet your monthly payment on a mainstream loan. During an interest-only period, it's easier to overpay during good times and deal with lower payments during bad ones.
  4. When you can make rather than lose money by investing the difference between interest-only and normal mortgage payments in stocks, a venture (maybe your own) or some other vehicle that generates high returns.
  5. When you need to maximize tax deductions. Mortgage interest (but not money that reduces the principal) is generally tax deductible, so it might be that every cent of your mortgage payment during the interest-only period is deductible. However, before you make a commitment, check with a professional who's qualified to give tax advice to make sure that will apply to your personal circumstances.

All those involve some risk, and some a lot. Everyone should carefully balance the risk and reward one of these mortgages can provide, and those who are naturally cautious are unlikely to proceed much beyond that weighing.

Can You Get An Interest-Only Mortgage?

For years after the credit crunch, interest-only mortgages all but disappeared. Lenders and borrowers both had badly burned fingers, and neither wanted to know about them. It's only been since maybe 2014 that they've become widely available again.

Well, "widely" may be an overstatement. That USA Today report quoted senior loan officer Scott Sheldon:

[These mortgages] are usually geared toward higher-net-worth individuals who are interested primarily in cash flow and otherwise have a lot of assets. We usually want 12 months of mortgage payments in the bank, in addition to the 740 credit score, in addition to the 25 percent down payment.

But things are changing, and just two days after that story appeared, Fannie Mae was reporting "mortgage credit standards are loosening gradually." So, in coming months and years, these mortgages might grow in availability and popularity. Chances are, you'll consider or dismiss having one yourself depending on the extent to which you're risk-averse.

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