Is an Interest-Only Mortgage Ever a Good Idea?

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Survivors of the Great Recession may remember that interest-only mortgages were a major factor in causing the housing crash and the ensuing economic train wreck. Yet in the last few years, these mortgages have reappeared as an option for some homebuyers. Should you consider getting an interest-only mortgage?

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What is an interest-only mortgage?

With a traditional, fixed-rate mortgage, you make a set payment over a set period of time, and the payment is applied to both the principal (the amount you actually borrowed from the mortgage lender) and interest (the profit the mortgage lender makes in exchange for lending you the money). Interest-only mortgages are structured in a totally different way: For the first part of the repayment term, often 10 years, you're only required to pay the interest that's due on the loan at a (usually low) fixed rate. Because you're not paying down the principal, your loan balance stays exactly the same during this time. When the interest-only period is over, your payment will reset to a principal-plus-interest payment, typically with a variable interest rate that may be substantially different from the fixed rate you paid at first.

How interest-only mortgages have changed

Before the housing crisis, mortgage lenders used interest-only mortgages to get people into houses they clearly couldn't afford. Because the initial interest-only payments are so small, homebuyers with very low income could still afford quite expensive houses. Their income requirements for the loan were calculated based on the interest-only payment, not the final (much larger) payment. Many borrowers didn't understand how their payments would change after the interest-only period ended, and when their mortgage payments dramatically increased, they ended up in foreclosure.

The current version of the interest-only mortgage comes with a much stricter set of requirements. First, interest-only borrowers are required to make at least a 20% down payment on the house. Second, only borrowers with an excellent credit score can qualify for these loans. And third, the borrower's income requirements are assessed against the full payment amount, not the initial interest-only payment amount.

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Interest-only pros and cons

Since you're only paying interest during the loan's initial period, your payments during those first few years are extremely small. That means you can put the money you'd otherwise be spending on mortgage payments toward some other purpose. However, interest-only mortgages are much riskier than traditional fixed-rate mortgages for several reasons.

First, during the interest-only period, you won't be building any equity in your house, so if your home drops in value, you'll immediately end up underwater on the loan. That means you'll owe more on the mortgage then your house is actually worth, and if you sell the home, you won't make enough on the purchase to pay off your lender.

Second, when your mortgage payments go up in the principal-plus-interest period, you may find it difficult to keep up with that greater monthly expense. Most people find that they naturally end up spending about as much as they earn, so during the interest-only payment period, other expenses will likely eat up your excess income. Then, when you're about to start paying down the principal, you'll find yourself scrambling to find the money to make that full mortgage payment each month.

Third, interest-only mortgages use a variable rate of interest after the interest-only period ends. If interest rates go up, your housing payment will increase as well. And given how low interest rates have been for the last few years, it seems likely that we'll see increases rather than decreases for the foreseeable future. In this kind of interest rate environment, a fixed-rate loan makes a lot more sense, because allows you to lock in the current low rate on your mortgage and protects you from future rate increases.

And fourth, with an interest-only loan you'll end up paying a lot more in interest over the life of the loan than you would with a standard fixed-rate loan. That's because for the first few years, you're not paying down the principal at all, so you're not making any progress on the loan. You can use this interest-only mortgage calculator to see the difference in total interest you'd pay on such a loan versus a fixed-rate loan.

For example, let's say you bought a $300,000 house and paid 20% down, or $60,000. Your mortgage balance would be the remaining $240,000 not covered by the down payment. Assuming a 4% interest rate (which is optimistic, as rates are likely to rise in the future) and a 30-year loan with a 10-year interest-only period, you would pay $205,000 just in interest over the life of the loan. A fixed-rate loan with the same terms would only cost you $172,500 in total interest, which means you'd save $32,500 over the life of the loan (or even more if you managed to pay it off early).

In short, interest-only mortgages are a bad idea for nearly all homebuyers. An interest-only mortgage is likely to tempt you into buying more house than you can really afford, and once your payment goes up, you'll end up in a world of financial hurt. You're much better off sticking with fixed-rate loans. If you're having trouble affording the home you want, check out low-down-payment mortgage programs instead of dipping a toe into the shark-infested interest-only waters.

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