Interest Only Mortgage Pros And Cons

In the world of mortgages, there are many options available for qualified borrowers, some better than others. These include traditional fully-amortizing 15-year or 30-year fixed-rate mortgages, adjustable rate mortgages, and interest only mortgages. To put it bluntly, interest-only mortgages are the least-desirable of the bunch.

What Is An Interest Only Mortgage?

With an interest only mortgage the borrower has the opportunity to pay monthly payments, for a predetermined period of time, on just their mortgage’s interest and not the principal. This time frame is usually between five to ten years; however, the borrower does have the option of paying down principal during the interest-only period. At the end of this period, the total amount of principal owed would not have been reduced one bit (unless you’ve been pre-paying principal, of course).

How Are They Structured?

Normally, an interest only mortgage is structured as a traditional 30-year mortgage with up to ten years of monthly payments on just the interest portion of the loan. As you might expect, the interest rate on these mortgages is usually much higher than comparable 30-year mortgages, however, since you aren’t paying on the principal, the total monthly payment is generally lower, at least at first.  After the interest-only period is over, there is generally a balloon payment due followed  by permanently-higher monthly payments. Few buyers plan on sticking around that long, however.  An interest only mortgage is almost always a last-resort option the buyer will opt to refinance out of at the earliest opportunity.

Advantages Of Interest Only Mortgages

Theoretically, the primary advantage of interest only mortgages is the lower monthly payment.  When times were good and home prices appreciating by the day it was possible to buy a property with no-money down, pay minimal monthly payments on an interest only mortgage while patiently waiting for values to go up, and then selling long before the interest-only period was up for a tidy profit.  Obviously, this trick only works in a bull market.

Another commonly-cited advantage of interest only mortgages is that they are more flexible than fixed-rate mortgages.  A family or borrower with fluctuating income may prefer the option of only making payments on interest during their months of leaner income. My opinion is that if you can’t afford a 30-year fixed mortgage, you can’t afford to own a home.

Disadvantages Of Interest Only Mortgages

With an interest only mortgage, there are a few issues borrowers need to be aware of. Do not be misled into believing these are low interest or low risk mortgages. They normally carry very high interest rates and are considered by most lenders to be very risky. Additionally, since most interest only mortgages are also ARMs, you could find yourself with an exorbitant monthly mortgage payment if rates move against you and you are for some reason unable to refinance (perhaps due to bad credit).

30-Year Fixed Vs Interest Only Mortgage

The primary difference between 30-year fixed and interest only mortgages is that 30 year mortgages amortize principal payments normally while interest only mortgages (surprise, surprise) do not.  Also, by definition 30-year mortgages are fixed-rate loans, meaning the interest rate will never change. Interest rates on most interest only mortgages, however, are adjustable, meaning they fluctuate up and down based on prevailing interest rates.

It would be unfair to say nobody should ever take out an interest only mortgage.  For some shrewd investors or perhaps some other ultra-specific situation, this type of mortgage might make sense.  But for 99.9% of borrowers, a fixed-rate mortgage is a far better deal.