Interest Only Loans Overview

What are interest only mortgages?

interior of a home | interest only mortgage When buying a house with an interest only home loan (or interest only mortgage), you pay only the interest owed on your loan each month when you make a mortgage payment, as opposed to traditional loans where monthly mortgage payments go towards both interest costs and the loan balance.

The option to only make interest payments lasts for a fixed term, usually between 5 to 10 years. Since each monthly payment only goes toward the interest, your loan balance does not decrease unless you make additional payments toward the principal loan amount.

During this time frame, you have the right to pay more than the interest payment if you want. However, if you opt not to pay toward the principal loan amount then the loan balance remains the same. To determine if an interest only loan is right for you, it's best to contact a lending professional.

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Interest Only Mortgage Benefits

Many borrowers find several advantages with an interest only mortgage including:

  • Lower monthly mortgage payment
  • Additional cash available to pay toward higher-interest debts
  • More control over cash flow
  • The entire monthly payment during the interest only period usually qualifies as tax-deductible. Be sure to consult your tax adviser. 
  • If it’s a short-term investment property such as a fixer upper, interest only payments help keep costs low so your money is available to be leveraged in other areas.

Once the interest only term expires, many homeowners choose to refinance their home, pay a lump sum, or simply begin the process of paying off the loan principal.  Payments that include the principal are of course much higher than those that only include the interest.

As with any type of loan, there are potential drawbacks to be aware of.

Possible downsides include:

  • Mortgage rate increases in an ARM loan may cause the payment to become unaffordable 
  • Homes may not appreciate as quickly as the borrower would like
  • Some borrowers may not be able to afford to pay the principal when the time comes
  • It may be difficult to build equity in your home with interest only mortgages unless you opt to make extra payments

There are further potential risks you should be aware of with interest only loans.  One such risk is that it is possible the home may be worth less than what is owed, or it will rapidly depreciate if housing prices fall. 

 

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Interest Only Mortgage Requirements

Since interest only loans involve increased risk for lenders, the requirements for these loans are somewhat different than a traditional loan.

Requirements include:

  • Ability to verify source income
  • Ability to afford higher payments when the rate changes
  • Higher down payment
  • Lower debt-to-income ratio

Generally, interest only loans are beneficial if one of the following guidelines applies to your situation:

  • You expect to sell your home or refinance it prior to the interest only period ending.
  • Your income heavily relies on bonuses or commission checks that come infrequently during the year; so you want the flexibility of making interest only payments during the times when your income is low and then paying more when your income increases.
  • You're looking for a first time homebuyer mortgage and you expect to earn significantly more income in the next few years.

Interest Only Loan Options

Some of the loan types that offer an interest only option include:

Alternatives & Advice for Interest Only Loans

While interest only mortgages are a good fit for some, not everyone can make such a mortgage work.  If you are unsure if an interest only loan is right for you, New American Funding can help you determine if other avenues are possible.

Alternatives can include:

  • Determining if you qualify for community housing programs that offer low interest rates or smaller fees for those wanting to purchase their first home - making owning a home more affordable
  • Shopping around for mortgage terms that fit your budget, which may include a fixed rate mortgage
  • Taking the time to save for a bigger down payment is also advisable so you can borrow less
  • Buying a less expensive house can mean that after equity is built, you can purchase a larger and more expensive home

Additional fees may be levied if the loan is refinanced during the repayment penalty period as well. 

To determine which loan type is right for your financial situation, it's important to discuss your options with an experienced mortgage professional.

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