Introduction to Interest-Only Mortgages

An interest-only mortgage is not like your father's 30-year fixed mortgage. It offers you the opportunity to take a big loan for small monthly payments for a specified number of years. This is especially helpful if you foresee a significant increase in income in the near future, but are strapped for monthly income now.

Understanding the interest-only mortgage

An interest-only mortgage is structured in two parts: an interest-only period, which can last anywhere from two to 10 years, and a principal and interest period for the remainder of the loan. Once your interest-only period ends, the loan balance amortizes over what's left of the term.

With a traditional 30-year mortgage, you make the same principal and interest payment each month. With a 30-year loan with a 10-year, interest-only option, your payments will be lower during the first 10 years, but will significantly increase during the final 20. If you can handle the increased payments after year 10, you'll achieve the ultimate result: your home will be paid in full.

Potential pitfalls

The benefit of the interest-only mortgage loan is that it leaves more cash in your pocket now. However, nothing will accumulate towards your home's equity. It's similar to renting, except that the interest may be tax deductible. Another scary possibility is that if your home's value drops, you may end up owing more to the bank than the house is actually worth.

Secondly, your payments at the end of the interest-only period will go up significantly. If you can't afford those higher payments, you'll need to refinance. You could then choose a traditional loan, or another interest-only mortgage. But a word of caution: another interest-only home loan will further delay the building up of equity in your house. And, if you're unable to get a loan, the bank can foreclose and you'll lose your house.

Your father may never have had the opportunity to buy more house than he could afford. But by understanding how an interest-only option works, you can take advantage of this new opportunity, and make your dad very proud.