Why an Interest-Only Mortgage Loan Sounds Attractive
In real estate today, it is common for people to purchase a new home with a mortgage loan. Mortgage loans can be structured in many ways, some of which appear more attractive than they are in the long run. When entering into a new home loan, it is important to understand the specific complexities and payments your loan will require. Certain mortgage loans, such as interest-only loans, have some initial benefits, but before entering into an interest-only loan it is important to be aware of the long-term consequences.
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About Mortgage Loans
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The most common mortgage loan today is the 30-year fixed mortgage loan. Alternatively, consumers have the ability to choose nontraditional loans, such as loans with interest-only payments. In the case of a 30-year fixed loan, the customer makes the same monthly payment every month for 360 months. Each payment contributes to both the interest being charged on the loan and some of the principal.
Why Interest Only Sounds Attractive
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In the case of interest-only loans, early payments do not lower the outstanding principal balance. Instead, the customer is only paying off the accrued interest over the last month. This makes payments lower upfront, thus appearing more attractive. However, because the principal is not being lowered each month, the customer is only paying rent to the bank for living in the house, rather than building home equity.
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Example
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For example, if you purchase a home with a 30-year fixed mortgage loan for $150,000 at 7 percent annual interest, your monthly payment will be $997.95. If you were paying interest only, your monthly payment would be $875.00, appearing to save $122.95 per month. However, with the 30-year fixed you have paid that $122.95 into the principal of your loan. In the second month, the interest paid will decrease slightly to $874.28. With an interest-only loan, you would continue to pay $875 in interest every month until a later date, when your payment would increase to make up for principal payments that were not made early on.
Benefits
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Interest-only mortgages generally do not require interest-only payments. If you have cyclical income due to a commission payment structure, it might be best to have a loan that requires just the lower payments. However, in months in which you have higher income, you can make larger payments to lower the outstanding principal.
You can also integrate an interest-only loan into an investment plan, though this is very high risk and is not recommended for most people. If you are able to find an interest rate higher than your mortgage interest rate through an investment, it may be better to put the extra money into the high-return investment and pay it into the mortgage at a later time. Again, this is very difficult and very risky, but can be profitable compared to paying your debt early.
Drawbacks
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If you do not have the conviction to make extra payments, this is not a good loan choice. The flexibility of this loan is a severe drawback if you go on just making interest-only payments for many months or years. The total cost of the loan will be much higher, and you will not increase your home equity.
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