There are a variety of mortgages designed to help people buy the homes they want, and interest-only mortgages offer a way for would-be homebuyers to get a loan with lower initial monthly payments than a traditional mortgage would have. However, under an interest-only mortgage, borrowers get those lower payments only for a certain term, and the trade-off is that once you start repaying principal, the monthly payments jump to much higher levels than they were in the beginning. That can force a borrower to refinance at an inopportune time or even to have to sell the home to avoid foreclosure. To help you understand exactly what you're getting into, this interest-only mortgage calculator gives you details on what interest-only mortgages look like and the increase in payments you can expect.
How interest-only mortgages work
Interest-only mortgages have a lot in common with fixed mortgages. They have repayment schedules that are based on certain terms, and they typically have fixed interest rates that the borrower can rely on paying throughout the term of the loan.
The advantage that interest-only mortgages have that fixed mortgages don't is an initial period during which the mortgage borrower has to pay only the interest due on the mortgage balance, without paying down any principal. Even though the early payments of a 30-year mortgage are typically mostly interest, you can cut your initial monthly payment by about 30% at interest rates near their current 4% level. For higher interest rates, the savings is lower, because more of your payments are going toward interest.
The trade-off is that after an initial period, you'll have to start paying principal. The longer the initial period, the more quickly you'll have to cram those principal payments in to get the loan paid off within the 30-year timeframe of the mortgage. So for instance, a five-year interest-only period gives you 25 years to repay the principal, while a 10-year period of making only interest payments leaves just 20 years for principal repayment.
An example of how interest-only mortgages compare to traditional mortgages
A realistic scenario can help you understand the situation more completely. Say that you want to borrow $200,000 toward buying a home, with prevailing rates at 4%. You're considering an interest-only mortgage with a five-year interest-only period and want to see how the payments compare.
When you use those assumptions in the calculator, you'll see that you would have an initial interest-only payment of $667 per month. That's almost $300 less than the $955 monthly payment that a traditional mortgage would cost. The downside, though, is that the interest-only mortgage doesn't provide you with any equity in your home over that initial time period. With the traditional mortgage, you would have paid down your principal to $180,895 during those first five years, building up nearly $20,000 of home equity.
In addition, after five years, you'll have to start repaying principal on your mortgage. At that time, your payment will be $1,056, or roughly $100 higher than it would have been under a traditional mortgage. More importantly, it will be almost a $400 increase from the interest-only amount, and that could impose a financial hardship that will make it difficult or impossible for you to afford your monthly payments if you're not prepared for the increase.
Be smart with interest-only mortgages
Many industry analysts believe that interest-only mortgages are too dangerous to use because, for many homeowners who can't afford higher monthly payments, they almost guarantee the need to refinance or sell the home by the end of the interest-only period. That can cause problems if everyone in a given real estate market is in the same predicament at the same time, looking to sell under the worst possible conditions.
However, there are situations in which interest-only mortgages make sense. If you're facing a temporary cash crunch but know that your income will rise by the time you have to make principal payments, then an interest-only mortgage can help you bridge the gap without having to wait to buy the home you want. Also, if you simply want to invest the difference and think you can earn more than the mortgage interest rate, then interest-only mortgages can help you maximize how hard your money works for you.
Interest-only mortgages have some attractive features, but they can also bring surprises if you're ill-prepared. By looking at what your interest-only loan will look like after the interest-only period ends, you can accurately assess whether you can afford to use one.