Do Interest-Only Mortgages Make Sense When Buying A Home?

Do Interest-Only Mortgages Make Sense When Buying A Home?

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When the real estate market began to buckle a few years ago, prices started to slip. Demand dried up, inventory of homes for sale ballooned, and suddenly, homeowners discovered they would have to entertain lower bids to sell their properties. This dynamic caught many new homeowners by surprise. Some had purchased their houses using interest-only (IO) mortgage loans, expecting their properties’ appraised values to rise. When values turned downward, these homeowners essentially became renters, paying a mortgage that reflected unrealistic values.

For these and other reasons, IO loans attracted a substantial level of criticism. But much of the negative press is overblown. For some people, this type of mortgage not only makes sense, but may be a smart decision depending on the circumstances. This article will offer a closer look at how these loans work, and when they are appropriate.

How Interest-Only Mortgage Loans Work

The interest-only monthly payments for any given property are calculated using the same amortization process as with a conventional loan. The difference is that the payments include only the interest – not the principal – due on the loan balance. As payments are made each month, the principal balance of the mortgage remains unchanged.

For example, suppose you took a $300,000 loan at 6.75% interest over a 30-year period. The interest on this loan would be approximately $1,688 each month. With a conventional mortgage that combines interest and principal, the payment would be approximately $1,946. An interest-only loan would require a $1,688 payment over a fixed term (typically, five years). During this time, the balance of the mortgage would remain $300,000.

At the end of the fixed term, the loan is amortized to include both interest and principal in the monthly payments. The homeowner must play “catch up” in order to pay the principal that was neglected during the fixed term. This is done on an accelerated payment schedule for the remainder of the mortgage.

When Are Interest-Only Mortgage Loans Appropriate?

Even though the press has been critical of interest-only mortgages for buying homes, this type of loan serves a valuable purpose in a few situations. First, many homebuyers expect to earn far more income in five to ten years than they earn today. An IO mortgage allows them to buy a larger home than would otherwise be possible.

Second, a lot of potential homebuyers receive a large portion of their income through bonuses or commissions. Because their monthly inflow may be limited, they benefit from the flexibility of being able to pay only interest. When they receive their bonus or commission, they can apply it to the principal balance of the loan.

An interest-only mortgage can also prove valuable if the homeowner invests the savings into an instrument that offers a higher return. A careful review would need to consider the tax deductibility of the interest as well as the person’s tax bracket and the taxable capital gains of the investment. However, those calculations are made easy with the variety of free tax calculators available online. Just plug in the info specific to your situation and let the calculator do the hard work.

The Potential Dangers Of Only Paying Interest On Your HomeOne of the risks of assuming an IO mortgage is that the home may fail to appreciate in value. If the homeowner must sell his or her house, the purchase price must be able to cover the balance of the loan. If housing prices have dropped since the original purchase, the homeowner will be forced to make up the difference, essentially translating into a financial loss.

It is worth noting that even a conventional mortgage is unlikely to shield the homeowner from this problem during the first several years of homeownership. The reason is because interest comprises a majority of each payment during the first fifteen years. While paying a small portion of the principal during this period helps, the problem still exists.

If you are considering an interest-only mortgage for buying a house, familiarize yourself with the pros and cons posed by this type of loan. While it may offer a good fit for your circumstances, it can also become a financial albatross.

Author: ParentingMaven

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