Interest-only Home Loans: Pros and Cons
Of all the different types of mortgages available, one you may not often hear of is an interest-only home loan. In this type of loan, instead of your monthly payment being a combination of principal and interest, you have the option for the first five to 10 years of the loan to make only interest payments. While at first glance you may decide this type of mortgage is either a very good or a bad idea, it has pros and cons, each of which deserves consideration.
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The Math
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An interest-only home loan, at least for a time, can significantly reduce your monthly house payment. For example, if you take out a home loan for $200,000 with a 4.75 percent interest rate and an interest-only option for the first five years your monthly payment will be $791. In contrast, if you take out a five-year adjustable rate mortgage with an initial interest rate of 4.75 percent, your monthly payment will be about $1,041. Over the five-year period, the difference comes to $15,000.
Flexibility
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Interest-only home loans offer flexible payment options. This can be helpful whether you are a struggling first-time homeowner, a homeowner with a fluctuating income or a personal finance whiz looking for asset management options. During a month when money is tight or when an investment opportunity that you feel makes better use of your money is available, you can choose to lower your payment. When additional funds become available, or when your investment pays off you can increase your payment to include the principal, or use your investment earnings to eliminate a chunk of the principal.
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Hedge Against the Future
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Getting an interest-only home loan allows you to place bets on tomorrow, a benefit that can be especially helpful if this is your first home. When you are young and just starting your career, this type of loan may allow you to go beyond a typical starter home and avoid selling and repurchasing every few years as you outgrow your current home. This in itself can be both time consuming as well as expensive.
Long-term Consequences
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The initial savings, flexibility and increased opportunity for investments that interest-only home loans provide also have a downside that could end up costing you your home. The two biggest risks you face, according to Bankrate.com, are an economic downturn that causes your home to lose value and the loss of your job. If either happens and you are making interest-only payments, not only will you have no equity in your home to fall back on, but you will most likely also owe more than it is worth. Another con of interest-only home loans is the size of the payment once the interest-only period is over. Unless you refinance the loan or make a lump sum principal payment, your monthly payment will significantly increase. For example, if the $200,000, 4.75 percent interest rate, interest-only option for first five years converts to 7 percent in the sixth year, your monthly payment will increase from $791 to $1,413 each month.
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