Interest only loans are unique options that make sense to a specific type of borrower. If you are in the market for a new mortgage, one of your options is an interest only mortgage. This is a type of loan where the borrower only pays the interest on the loan for the first 5-10 years of the loan.
After that term is over, the borrower has to start paying principal as well. That is why most people with an interest only mortgage will refinance at that point. An interest only loan is riskier than a conventional loan where you pay both interest and principal from the beginning of the loan.
However, that is not to say that an interest only loan is not a good idea for some buyers. Here are some signs that an interest-only mortgage could work for you:
#1 You Want to Buy More Home Now
The biggest advantage of an interest only mortgage loan in the short term is that your initial payments are much lower. This will allow you to buy a more expensive home. Why would you want to do this?
A good example would be if you need or want to buy a home in a more expensive part of the country. Say that you live in San Francisco and you want to buy a home. Real estate is very expensive in San Francisco, so you could decide to get an interest only mortgage, thereby you can afford the loan.
When the initial interest only rate term expires, you would need to refinance the loan or be prepared to pay the higher payment.
This type of situation could work for someone who anticipates that they will be making more money in a few years. Or, they think that they will be able to refinance at a lower rate at that time.
You should remember that if you are depending upon reasonable interest rates later on to afford your home, you are taking a financial risk.
The Interest Only Mortgage option makes sense for a select group of borrowers, but responsibility is key!
#2 Your Home Will Be Sold in a Short Time
If you are certain that you will need to move in a year or two, then you can make an argument to get an interest only mortgage loan. For instance, if you are 100% sure that you are going to be transferred or take a job in another city in two years, getting an interest only loan could make sense.
You just need to make certain that you will be able to get the home sold in your desired time-frame, before the higher rate kicks in.
#3 You Want the Low Payment Now
Some people get the interest only mortgage or HELOC loan because they just want a lower payment right now. They think that they will be able to handle the higher payment later because they will be earning a higher salary.
Sometimes this works out fine, and other times it does not. Make sure that you will be able to handle the higher payment down the road if you make this choice.
#4 You Want To Invest the Difference
Some people own real estate investments or other investments, and want to put the money they are saving from the interest only loan into those investments. This also can work out fine if you are able to definitely get a higher rate of return.
Be sure that your investments are going to pay you an adequate return so that the higher risk is worth it.
#5 Writing Off Mortgage Interest
There are some situations where a buyer could want the interest only payments so that they can write off the mortgage interest on their tax return. The entire mortgage payment in the introductory period is interest, and this can make a big difference on your tax bill.
If you and your tax professional are looking for a big tax savings for some reason, this could be a good move. Find out what refinance closing costs are tax deductible by discussing your situation with an experienced tax adviser.
What is the level of risk associated with interest-only mortgages?
Opting for an interest-only mortgage is a decision that comes with considerable risks and costs, making it an unsuitable choice for the majority of borrowers. Despite this, a select few individuals may find success with interest-only arrangements, as their repayment strategy generates returns surpassing the amount required to settle the initial mortgage.
What are the drawbacks of interest-only mortgages?
Following the interest-only period, there is a potential for your repayments to rise, and this increase may be challenging to afford. Additionally, the value of your asset, whether it be a house or property, minus any outstanding debt, can leave you vulnerable to market fluctuations or changes in your circumstances, particularly if you intend to sell.
Interest only loans should only be taken out with care because there is significant risk involved with them:
- If interest rates are rising when you need to refinance, you could have a sky high payment that you cannot afford. Many people in the mortgage crash lost their home on interest only mortgages.
- Many people lack the discipline to invest the difference. They just spend the money. If you do not have financial discipline, an interest only mortgage is a bad idea.
- Your income may not increase as fast as you thought. If you are not making as much money in a few years, or if you lose your job, you could be unable to make your payments.
- The home may not appreciate as quickly as you thought and you could have trouble refinancing. This is another common problem that many borrowers found in the mortgage crash of 2008.
The Reality of Interest Only Mortgage Rates for Borrowers in 2023
There are many reasons that someone could decide that an interest only mortgage loan is for them. In the right situation, it is a useful financial tool. You just need to be sure that you are getting the loan for the right reasons. If so, paying interest only on your loan for five or seven years can yield financial benefits.