What is an Interest Only Mortgage?
You may have heard of the infamous interest only mortgages during the housing crash, portrayed as the villain in the story of the American dream. You can have it all – a bigger house in a better neighborhood – while making lower payments by only paying the interest on the loan.
Of course you will have a higher income 5-10 years from now to make payments when the interest only home loan period expires. Everyone wants to believe they will be more successful in the future, as we expect to progressively earn more in our career.
But what if you don’t? How does an interest only mortgage really work? Who can benefit from interest only mortgages? Is an interest only home loan right for you?
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The most common home loans are structured in a way that leaves the home owner responsible for paying some interest and some principal, paying both at once in each payment. In an interest only mortgage, the home owner pays interest only each payment for a structured period of time (usually 5-10 years). During this time, the principal (amount owed on the loan) will not change.
Interest only mortgages reduce the monthly payment for the home owner. This allows a home owner to buy a more expensive house now, rather than buy a less expensive house with higher payments in a typical fixed rate mortgage. After the interest only mortgage period, payments increase to begin to cover the loan principal.
The interest rate on interest only mortgages is typically at an adjustable rate. This means that the interest rate and required monthly payment can change over the period of the loan. The interest rate and required payment can change monthly or yearly as determined by the terms of your loan.
The borrower is required to pay at least the interest in an interest only mortgage. However, the borrower has the right to pay more toward their principal if they desire. The Mortgage Professor website has a great example of payment changes in an interest only mortgage:
A borrower has a 30-year loan of $100,000 at 6.25% interest.
- Interest only mortgage payment: $520.83
- Standard mortgage: $615.72
Lenders also may offer an interest only home equity loan to borrowers. In this loan, the borrower takes out another loan using the equity of their home, as appraised by the lender. In an interest only home equity loan, the borrower may only pay interest on the loan for a certain period of time similar to other interest only mortgages. However, it appears as though many lenders are moving away from offering an interest only home equity loan in order to protect borrowers.
Advantages of an Interest Only Mortgage
There are several advantages offered to potential home buyers through the use of interest only mortgages. Some of the advantages of interest only home loans are:
- Low monthly payments for an extended period of time
- Extra money can be used for other investments
- The interest only mortgage period is tax deductible
- The buyer can purchase a more expensive home
- Increased payment flexibility for buyers with fluctuating income
- Can be beneficial if you seek to quickly turnover the property
The most attractive benefit of interest only mortgages for consumers is the ability to get the house you want at a lower monthly price. A buyer can qualify for a larger home loan based on their income because the interest only mortgage payment is lower than the payment in a standard fixed rate mortgage. This basically allows the buyer to purchase more home than they could normally afford, while making lower payments for years.
Who Can Benefit From An Interest Only Mortgage?
For those seeking interest only mortgage loans, the low payments can allow you to free up extra cash to put toward other investments. For example, a buyer can build wealth by investing excess cash flow into a stock portfolio. If their return on investment is greater than the mortgage interest rate, they are able to expand their investment.
Interest only mortgages allow buyers to purchase more expensive homes than they could afford under a standard fixed rate home loan. Since the monthly payment requirement is lowered in an interest only mortgage, lower income buyers can qualify for higher loan amounts. Therefore, an interest only mortgage allows you to purchase a more expensive home than you could typically qualify for.
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Interest only home loans can be a great opportunity for buyers who have an irregular income. For example, if you make commissions or have seasonal wages, an interest only mortgage allows you to make interest only payments during low-income periods and pay off principal during higher-income periods.
If you are planning on quickly turning over the property, an interest only mortgage may be an advantageous financial tool to explore. Buyers who are interested in markets with price appreciation who are trying to make a financial gain can benefit from taking out an interest only home loan. The more expensive the house the buyer invests in through a strongly appreciating market, the more financial gain possible.
Test Your Strategy: An Interest Only Mortgage Calculator
The website Bankrate offers a mortgage interest only calculator that can help you test your strategy while seeking an interest only home loan. The calculator allows you to enter a variety of criteria such as the mortgage amount, term in years, interest only period, and interest rate. Then the calculator will determine an interest only payment amount.
Disadvantages of an Interest Only Mortgage
There has been a great deal of controversy surrounding the existence of interest only mortgages. A variety of criteria have been established to help buyers determine if an interest only mortgage is right for their needs. Although an interest only home loan may be beneficial for certain buyers, a variety of disadvantages should be noted:
- Possibility of rising mortgage rates
- Lack of self-discipline could make larger payments more challenging
- Inability to make larger principal payments after the interest only mortgage term
- Instability of income
- Lack of home value appreciation
There is always the possibility that mortgage rates may rise and the homeowner could struggle to make the mortgage payments plus principal. The FDIC offers a great theoretical scenario that reveals the disadvantages of an interest only mortgage.
For example, a potential home owner may be able to afford a payment of $1,100. This would allow the buyer to qualify for an $180,000 mortgage, roughly. A lender could then offer the potential buyer an interest only mortgage payment of $1,100 for a $215,000 mortgage. The loan payments could jump to $1,340 or more depending on the rate.
This would be a serious disadvantage for a buyer who has not considered this increase. If a buyer loses a work opportunity, doesn’t finish an expected degree, or other condition that would increase their income, they may struggle to meet these larger payments once the interest only mortgage period expires.
It’s a Trap: Hazards of Interest Only Mortgages
As noted in the section on disadvantages of interest only mortgages, there are a variety of potential hazards involved in interest only home loans. A variety of protections have been put into place since the subprime mortgage crisis that created tougher restrictions on interest only mortgages. This removes a great deal of risk from the general public seeking home mortgages. A great deal has changed since the mortgage crisis, and very few individuals are offered interest only mortgages today.
The interest only mortgages offered today are mostly jumbo loans targeted at wealthy buyers. An interest only jumbo mortgage is a loan that exceeds the limit of government-backed loans, which is $417,000 in most areas. Generally, those who qualify for such loans are among the wealthy, lowering the chances of missing payments and default.
High Qualifications for Today’s Interest Only Mortgages
Since the mortgage crisis, a variety of tight restrictions has been placed on lenders that offer interest only mortgages. For example, EverBank offers an interest only jumbo mortgage. Borrowers must have a credit score of 740 or above, make at least a 35% down payment, and have a debt-to-income ratio of 43% to qualify for this interest only mortgage.
Most interest only mortgage loans today require the buyer to have a solid debt-to-income ratio. A debt-to-income ratio compares the percentage of a borrower’s monthly income with their monthly debt payments. This qualifier helps insure that the borrower has enough free cash to make larger payments.
Prior to the mortgage crisis and recession, lenders would often qualify borrowers for an interest only mortgage simply based on the interest payment. In today’s housing and lending market, borrowers must qualify based on their ability to make the larger payments of interest plus principal. This protects borrowers from price shock once their payments rise after the interest only mortgage term.
There are a variety of interest only mortgage lenders in the housing market today. A web search reveals that many of these interest only mortgage offers are nonqualified loans, meaning that they do not meet the government’s standards for less risky mortgages. In this section, we will reveal a few lenders that offer interest only mortgages to borrowers, but you would have to inquire using your personal financial information to understand if these mortgages would be predatory toward your financial situation.
One finance company that offers interest only mortgages is called SoFi. SoFi claims to be a “modern finance company that’s fueling the shift to a bankless world.” Rather than simply use a credit score or typical bank figures to determine eligibility, SoFi claims to use a holistic approach to review the financial situation of each potential borrower. Their interest only mortgage is quoted as requiring a 15% down payment on mortgages up to $3 million, requiring borrowers to pay interest for the first 10 years of the 40-year loan (without mortgage insurance).
Typical brick and mortar banks such as EverBank and Citizens Bank offer interest only mortgages to potential borrowers as well. However, these banks focus more on interest only jumbo mortgage offers. Brick and mortar banks appear to be very cautious when discussing interest only mortgages and offer cautionary tales on their website for borrowers. These loans are generally tailored to very wealthy borrowers under strict criteria to lower the risk of default.
Is an Interest Only Mortgage Right for Me?
Are you wondering if an interest only mortgage is right for you? Since the mortgage crisis and the recession of the late 2000s, financial experts have become very critical of interest only mortgages for the everyday home buyer. This cautious stance is critical in protecting borrowers, as many people found themselves in interest only mortgages that they did not understand, they could not fulfill, or that did not produce the wealth necessary to remain in good standing.
Since this time, there has been an emphasis on placing strict standards on home loans offered by lenders. The government developed what is called qualifying loans, which help consumers decipher between reliable and predatory loan terms. It is important to note that the types of interest only mortgages discussed here are not qualified loans, giving borrowers a message of caution when seeking an interest only mortgage.
If you have considerable wealth and are interested in buying a home with a large mortgage, then you may stand to benefit from an interest only mortgage. Also, if you have seasonal earnings, rely heavily on bonuses, or work on commissions, you could potentially benefit from seeking an interest only home loan.
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