Interest-Only Mortgages

Interest-only mortgages differ from traditional mortgages (where the monthly payment is made up of both a principal and interest amount) in that the borrower only pays back accumulated interest each month. For example, if you make a mortgage payment of, say, $1,000 on a traditional principal-and-interest loan, in the beginning less than $100 will be applied monthly toward the principal, while the remaining $900-plus is used to pay interest. With an interest-only loan, however, you're only need to pay the monthly interest amount. You can choose a mortgage with an interest-only term of one-, two-, five- or ten years, or up to the life of a traditional loan (25 or 30 years). Of course, with the latter examples, you'll be responsible for a huge balloon payment at the end of the loan.

Some homeowners use this opportunity to put money into savings or an IRA for the future rather than paying it into principal. Years ago, interest-only mortgages were very popular until wartime, when homes began to depreciate rather than continuously go up in value. This forced many homeowners into foreclosure because their homes were no longer worth what they owed on them.

British homeowners that have interest-only mortgages often arrange to open an Individual Savings Account (ISA) or other investment vehicle that's designed to provide them the money to repay the principal balance when the interest-only mortgage's term is up. If the investment performs as expected, the funds will be there when needed. However, if the investment doesn't do as well as expected, the borrower may find him- or herself short of the cash necessary to retire the loan. Or, if the borrower is putting money into a plan for paying off the principal balance but uses some of the money for a vacation, he or she may again come up short when it's time to pay off the mortgage balance.

People have often chosen interest-only mortgages in recent years to take advantage of lower interest rates and a smaller house payment, especially if they plan to sell the property within a few years. Historically, most homes appreciate from 6- to 7 percent annually, so after a few years they're able to sell their home, pay off the mortgage balance and pocket a tidy profit at the same time. But during times when home values are receding, interest-only mortgages can cause serious financial problems for homeowners who were expecting build equity through property appreciation.

Regular principal-and-interest mortgages are still, by far, the most popular kind of mortgage. The monthly payments are higher than for an interest-only mortgage, but the borrower typically makes the payment with the intent of keeping the home (at least for an extended period) and simply paying down the mortgage. If all the payments are made as scheduled, the principal is fully retired at the end of the loan's term. Conversely, interest-only mortgages are not ideally suited as a long-term-financing vehicle. They should only be used after careful consideration and the development of a suitable exit strategy.