An interest only mortgage is one in which you make only interest payments for a period of time. A third of all new mortgages are interest only mortgages.
Contrast this to traditional mortgage that pays back the mortgage balance you took out to purchase your home. Many traditional mortgages are "amortized" over 30 years; that is, the amount you pay every month pays both interest and helps reduce the balance of the loan; so at the end of 30 years the loan is completely paid off.
=== Why are Interest Only Mortgages Attractive? ===
Interest only mortgages allow you can buy a larger, more expensive home in a better neighborhood.
Consider a traditional $250,000 mortgage for 30 years at 6.35% interest. The principal and interest payment is $1,555.59. But, the interest only mortgage payment is only $1,322.92--a monthly savings of $232.67. This makes homes more affordable.
And, for nearly the same traditional monthly payment (of $1,555.59 for a principal and interest loan), an interest only mortgage payment (of $1,555.75) allows you to get a loan of $294,000. Adding $44,000 to the loan amount could easily let you afford a larger home in a better neighborhood.
The short term effects of the interest only mortgages are:
1) Homes are more affordable so more people can buy homes
2) People can buy more expensive homes
Another way of looking at interest only mortgages is from a real estate agent's perspective. The interest only mortgage allows real estate agents to sell more homes because they are more affordable. And, interest only mortgages allow real estate agents make fatter commissions on more expensive homes.
=== What are the Downsides of Interest Only Mortgages? ===
Adjustable Rates: Most interest only mortgage loans are adjustable. That is, as key interest rates change, the interest payments on the loans change. Since interest rates have recently been climbing, eventually the monthly mortgage payments will also rise.
Those home owners with adjustable interest only mortgages will find their monthly payments higher than when they first purchased their home. If their income has not kept up, they will find it increasingly difficult to manage their mortgage payments.
Limited Term: Not only that, but depending on the terms of your interest only mortgage, your interest only payments may last only a few years. You could be expected to start making principal payments in five, seven or ten years. Once the interest only period ends, your monthly payment will go up because then you'll be paying on both principal and interest.
Many Americans are living on a financial cliff. They save little, spend most of what they earn, and are sinking deeper into debt every year. If you bought the largest interest only mortgage you could afford, you could find yourself in the difficult position of defaulting on your mortgage.
Real Estate Price Uncertainty: Also, the past decades have seen housing prices increase, seemingly without limits. As the selling price of your home increases, you essentially are building equity. When you sell your home for more than you paid for it, you're making a profit on it's increased value.
Money Magazine reports that many home prices have gone up five times as fast as personal income. They credit home price inflation to a large extent to the interest only mortgage loan.
But, Forbes magazine indicated that the housing prices on the coasts have peaked. Rising interest rates have increasingly made expensive homes less affordable. With fewer potential buyers, expensive homes are harder to sell and their prices could eventually drop.
The theory many home buyers have used in the past is that if home prices keep increasing, the profit you can make from selling your home can be enormous--even if you never pay down your mortgage loan. This positive outlook is merely one form of real estate speculation. It may be worth while applying Alan Greenspan's comment about "irrational exuberance" to holders of interest only mortgages. He said, "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"
But, if rising interest rates make expensive housing less affordable, and if retiring baby bombers begin to seek smaller, less expensive housing, then the prices of real estate could stagnate or even decline. This could place the interest only mortgage holder in the position of being "upside down" on their loan, owing more than their property is worth.
=== Is an Interest Only Mortgage for You? ===
There are certainly situations in which an interest only mortgage can be a valuable option.
Interest only mortgages can be useful if you are a savvy investor looking for cash-flow from income producing real estate. You will likely have investment property in several markets and a decline in one market could be offset by an increase in another market.
If you can obtain an interest only loan at a rate significantly below your traditional mortgage, you can take advantage of it's lower rate. Just because it is an "interest only mortgage" does not mean, however, that you must only make minimum payments for interest. You can add money to you payment to decrease the principal (loan amount). Because your interest charges are less, by making the same monthly payments as before you can more rapidly reduce the amount of your debt.
Or, you could use the money you would have paid in principal payments to build equity by making improvements in your home--just be sure the improvements really add value to your home. For example, kitchen and bathroom upgrades usually add value to your home, but adding a built-in pool often does nothing to improve your home's resale value.
Refinancing a partially paid for home with an interest only mortgage can free up money for other investments. You will still have equity in your home even if your home's selling price declines somewhat.
=== Summary ===
Overall, you need to understand both the advantages and disadvantages of an interest only loan.
If you are buying a home merely because you can afford the payments, you may be in for an unpleasant financial education. So, evaluate your situation carefully before you choose an interest only mortgage.
