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How Does an Interest-Only Mortgage Work?
Interest-only mortgage loans are relatively new products in the industry. A market or less than market interest rate will be offered and the lender requires a payment only equal to the interest on your balance. The interest rate may change at specified intervals or increases could be agreed upon in advance of closing. An interest-only mortgage can be either a very beneficial product or a loan that you might come to despise. Much depends on your
- Financial situation,
- Plans for the property securing the loan,
- Frequency of the interest rate adjustments, if any, and
- Your personal outlook on real estate and finances.
For instance, if you're paying “market rate” interest, the difference in the first few years of the loan will not differ greatly from a normal first mortgage, since over 90% of your monthly payments will go to pay interest anyway. The “cross-over” (when you pay more to principal than to interest) usually doesn't occur until sometime in the 11th
year of a 30-year mortgage loan anyway. Also, if your intention is to keep your property and your loan long-term, an interest-only mortgage loan may become a curse rather than a benefit.
However, often you might be able to get an interest-only loan at below market rates, which sometimes will result in a monthly payment 30-50% less than a normal fixed rate mortgage loan. The obvious benefits of a program like this –
- Much easier qualification rules or the ability to qualify for a larger loan,
- Greatly improved cash flow every month, the excess of which could be applied to the principal on your loan, and/or
- As long as you are not mortgaged to the “max”, it is possible that in rapidly appreciating value periods, your property will increase in fair market value (FMV) fast enough to allow you to sell for a good profit or refinance to a low rate normal fixed or adjustable rate mortgage loan.
An interest-only mortgage loan is definitely not for everyone. If you have a problem with budgeting, disciplined spending habits, or have wildly irregular income patterns, this product may be beneficial (lower monthly payments) or detrimental (no principal payments, spending above reasonable budget amounts, etc.), depending on your financial condition and habits. Be honest, not greedy. If you believe you will not allocate extra cash to principal, you might be better off with a normal fixed or adjustable rate mortgage, which force you to reduce principal and budget effectively.