A Review of Interest-Only Mortgages – Considering The Pros and Cons
An interest-only mortgage is an arrangement that allows the borrower to pay only the interest on the amount borrowed, for the first portion of the mortgage term. Then after a set time; anywhere from one to fifteen years; the borrower must start paying principal, in addition to the interest. This type of mortgage has both its advantages and disadvantages.
The monthly payment on an interest-only loan has both good and bad aspects: It is good for the first portion of the mortgage; because it is a low, manageable amount for the borrower. However, when the borrower has to start repaying the principal as well, the monthly payment suddenly jumps to a much higher amount. If the borrower was not planning well for this increase, he might not be able to afford the higher monthly payments.
The overall cost of an interest-only mortgage is one of the biggest disadvantages to the borrower; because he is not reducing the principal balance at all during the interest-only portion of the loan, his interest payments are the same amount every month, instead of going down gradually like on a conventional loan. A 30-year mortgage for $180,000 at 6 percent interest with interest-only payments for the first 10 years, and a conventional amortization for the last 20 years, costs a total of $237,498.22 interest. In contrast, if the same $180,000 were amortized over the full 30 years at 6 percent interest, the total interest cost would only be $208,508.74.
Because people pay more interest on an interest-only mortgage, they will be able to deduct more on their taxes. Interest on mortgages is tax-deductible for people who itemize their deductions, therefore an interest-only mortgage will allow the home owner to deduct the full amount of the payment, during the time they are paying only interest. This effectively reduces the interest rate of the loan, because the home owner does not have to pay taxes on any of the money used to make payments.
People who buy a home are often looking to build equity; meaning that they want to have the home become worth more than the remaining mortgage balance. An interest-only loan leaves the equity question in the hands of the market, because the home owner does not build any equity by making principal payments during the interest-only period. Therefore if the market is trending upward, the home owner will build equity without paying a penny, just because the market value of the home increases. However if the market is slipping, the home owner could have negative equity and will owe more on the mortgage than the home is worth. This situation makes selling the home very difficult, because the home owner must pay the lender the difference.
Any would-be property buyers should be sure to weigh the pros and cons of every type of mortgage, before commiting to a purchase.