Interest-only loans had a bad name some time ago. In a way, their structure coupled with falling home values caused homeowners to default on their loans and lose their homes. They however remain an option in today’s housing finance. If you were shopping for a mortgage, would you be interested in an interest-only loan?
What’s Up With Interest-Only Loans
To be fair, interest-only loans have their pros and cons. They start out with a really low rate. This teaser rate will remain the same for the next five years or 10 years, as applicable. During this period, you can opt to pay the interest portion of the loan only.
This gives you the flexibility to make really low payments on your loan during the so-called interest-only period or put in extra payments toward your principal. The introductory rate period is also an opportune time to build your wealth through investing while your mortgage payments are still low and tax-exempt.
When the fixed rate period is over, the loan will amortize like any traditional mortgage. It’s either you:
- Pay off the entire loan amount as some interest-only lenders require.
- Make interest + principal loan payments.
- Refinance to a new interest-only loan to lower the monthly payments or into a more stable loan.
- Sell the home before the intro period expires.
It’s when the introductory period expires that the risks of interest-only loans appear. The rate is bound to adjust and could go higher, thus increasing your monthly payment.
If you’ve been paying the interest of the loan only, your home would have little equity. This poses a problem when you refinance or sell your home. More importantly, housing prices depreciating will negatively affect your equity position as noted above.
Are You an Interest-Only Borrower?
Because interest-only loans can be tricky and work differently from the usual conventional loans, they appeal to a certain borrower group. Find out if you fit the profile of an interest-only loan borrower:
Financial capacity. You may be someone (i) who has irregular income and wants to make minimum payments at the onset of the loan and (ii) who expects a salary increase or income boost to support any payment increase when the rate resets.
Opportunity. Take out an interest-only loan if you are financially savvy and disciplined to handle your extra funds when payments are still low. You can either invest in other investment vehicles or make prepayments so you can pay off the loan faster.
Length of stay. You don’t intend to stay long in the house and plan to sell it before the fixed-rate period expires.
There Are Ways
Interest-only loans are not exactly bad, you just have to know how to handle the loan to make it less risky for you.
1. Buy a house that you can afford. When it’s time to make full payments, you can be sure you’ll be able to continue paying.
2. Save up for a down payment to build equity. Having equity in store will help you a lot when you need to refinance or sell the home.