Interest-Only Loans: Good or Bad?

The question of whether interest-only mortgage loans are good or bad cannot be answered with a simple “yes” or “no”, but with a very definite” it depends”. The prospective borrower must take into account numerous personal factors as well as the specifics of the loan itself in order to decide if it is the proper financial vehicle for him or her.

The interest-only loan is generally based on an adjustable-rate mortgage (ARM). This usually makes the initial interest rate of the loan lower, and thus easier to qualify for. Add to this the option of only paying interest on the money borrowed, and it’s quite effortless to see why these loans have gained tremendously in popularity. The monthly savings over a normally-amortized mortgage loan can quite easily be several hundred dollars. And with home prices continuing to rise, prospective buyers have found it increasingly more difficult to qualify for traditional loans.

The interest-only period of the loan can vary; generally it is five or ten years. After that, the loan payments amortize to pay off the loan during the remaining term. This will mean substantially higher monthly payments, so the borrower must determine whether or not this will constitute a financial difficulty. Also, the homeowner must be aware that during the interest-only payment period, there will be no equity gained in the property unless its’ appraised value rises. If values were to fall, refinancing or selling the property could be very challenging.

Statistics show that the average American family relocates every five to seven years. This potentially makes the interest-only mortgage even more attractive to homeowners. They can save hundreds per month while still enjoying a bigger home than they could normally afford. They could also invest this savings in other vehicles that could have higher rates of return. And since they would be selling and moving in five years, they would not have to incur the larger principal-and-interest payments when they became due. As long as home values continued to rise, and the loan did not have a very strict prepayment penalty, they could gain equity on each subsequent home that they purchased interest-only, while putting off any principal payments indefinitely.

However, if home values were to fall, or if a prepayment penalty prohibited the sale of the property or refinancing, the homeowner could find him- or herself in very serious trouble. If they were not ready for the larger amortized payments, foreclosure could be on the horizon.

Option ARMs give the homeowner the flexibility to make minimum, interest-only, partly- or fully-amortized monthly payments depending on his or her changing financial condition. Great care must be exercised with these loans, because the possibility of negative amortization can occur. If the monthly payment that is made is not enough to cover at least the interest accrued, the deficiency will be added onto the principal of the loan. The homeowner could end up owing more on the home than was originally borrowed.

If you're contemplating an interest only equity loan, educate yourself with all of the information that you can get your hands on. Another good source to help you decide if an interest-only mortgage is right for you can be found at Mortgage101. Analyze your own financial situation, as well as your short- and long-range goals. Study the subject of interest-only loans vigorously. Then, and only then, will you be equipped to make the decision that’s best for you.

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