Interest only mortgages have soared in popularity in recent years. As housing prices skyrocketed, many buyers found that the only way they could afford to get into the house of their dreams was to choose an interest only mortgage. This was especially true in regions of California and the Northeast US, where housing prices are among the highest in the country.
An interest only mortgage is pretty self explanatory. You only pay the interest on your loan for a specified period of time (usually around five to seven years).
Then you can either refinance at current interest rates, pay off the balance as a lump sum, or begin paying off the principal via significantly higher monthly payments.
The risks of an interest only mortgage should be obvious. For several years you will be making payments without gaining any equity in your home. There’s a chance you may not be able to afford the higher payments after the initial term is up. And if housing prices drop, you could find yourself owing more than the house is worth.
For these reasons, interest only mortgages are not for the average person. But they can come in handy under the right circumstances.
For example, if you expect your income to rise significantly before the payments go up. Perhaps you are in medical school and need to keep your payments as low as possible. When you graduate you expect your salary to be more than enough to cover the additional principal payments.
Or perhaps you are owner of a new business just getting off the ground and in need of cash. You are confident that in a few years your business will take off and your income will increase.
Others who can benefit from interest only mortgages are salesmen or executives who are paid mostly in commissions or bonuses. The lower payments can help get them through the dry times. And they can pay extra toward the loan principal when the bonus checks come in.
Others choose an interest only mortgage so they can use the money saved for investing. They believe the return on their investments will be high enough to justify the risk. Of course if their investments don’t turn out as planned they could find themselves in trouble.
If none of these situations apply to you (and even if they do), be wary of interest only loans. Even if it is the only way to buy the house of your dreams, you must remember that it can turn into a nightmare if you miscalculate.