With most mortgages, the monthly payment consists of a portion of interest and principal, which means the borrower will pay on both at the same time. Interest only mortgages are different, as they allow homeowners to pay only interest on the monthly payments for a specific amount of time, (usually between five and ten years), while the principal balance on the loan remains unchanged.
The main advantage to an interest only mortgage is the monthly payments are reduced, allowing borrowers to buy a more expensive home than they could otherwise afford.
Borrowers who typically consider interest only mortgages are the following:
Interest only mortgages were popular during the housing bubble, and remain a popular loan option to qualified buyers. Still, it is important to understand that new rules enacted by the Consumer Financial Protection Bureau, which went into effect in January 2014, exclude interest only mortgages from Qualified Mortgage status. Qualified Mortgage Status protects lenders from liability of the loan if the loan later defaults.
Today, interest only loans are generally only offered to well-qualified buyers who can afford a large down payment and have substantial assets.
Because interest only mortgages do not amortize, borrowers can more quickly become underwater on the loan if the real estate market turns and home prices drop. The best way to avoid this, is to provide a substantial down payment, which gives the buyer immediate equity in the home.
Monthly payments can also rise dramatically when the interest only period ends, so buyers must be sure they will be able to afford the larger payments when the time comes.
Borrowers should also be aware that it can be harder to refinance the mortgage with an interest only loan if home values do not increase and the home has no equity.
The strict requirements for an interest only loan can also make this option impossible for some borrowers, as most lenders require a large down payment, excellent credit and substantial assets.
While interest only mortgages are not for every borrower, they do offer a great deal of benefits to the right buyer with a unique situation.