Taking out an interest-only mortgage as a way to borrow more and pay less on a monthly basis can be dangerous. In looking for an affordable way to purchase your dream home, you may have considered an interest-only mortgage.

It sounds like a good deal: qualify for a higher loan and make lower monthly payments for a set period of time until your financial situation improves. Unfortunately, many people find themselves in the hole when the set period is over and it's time to start making larger payments.

Eric Tyson, one of the authors of Mortgages for Dummies says, "My co-author and I are proud of the fact that since the very first edition of our book, we've been telling people to stay away from the interest-only loans and no down payment loans that were stretching them way too thin."

What is an interest-only mortgage?

When you are talking about interest-only mortgages, it's important to know the difference between the interest and the principal. The interest is the fee that the homebuyer pays to borrow money from the lender. The principal is the actual loan amount. It's also important to know that an interest-only mortgage isn't an actual loan, but an option that can be attached to any type of home mortgage.

So, what is it? An interest-only mortgage is a loan where the borrower only pays interest on the principal balance (or the total amount due) for a set period of time.

During that period of time, the borrower does not contribute to the principle and therefore, does not pay off the actual loan. In a typical amortized mortgage, a person's monthly payment goes to both the principal and the interest on the principal.

The result of this is that the borrower has substantially lower payments during the first part of the loan. However, because they are not paying the principal, the homeowner is not building any equity.

Also, just as with any loan, there are all kinds of interest-only loans. Most have an adjustable rate, which can be set for a period of time before it becomes variable.

Who are they good for?

Interest-only mortgages are good for people who expect to earn more money in the near future and want a loan/home that is larger than what they can presently afford. This can be a risky bet in today's economy.

They are also good for people with wildly fluctuating incomes. You can pay only the interest during a lean month and part of the principal on a good month.

People who plan to flip their homes or refinance before the interest-only period is over can also benefit.

Why should consumers avoid them?

Interest-only loans are risky for people who end up getting a loan that they cannot afford any other way. It goes without saying that if you have cash flow issues that aren't resolved before the interest-only period is over, you aren't going to be able to make the higher payments.

Also, during the interest-only part of the loan, you are not paying the principal and therefore you are not building equity in your home. This can end up being a big speed bump if you plan to refinance when the interest-only period is over.

Why do interest-only loans have a bad name?

They got a bad name during the housing bubble. Many people used them to get bigger mortgages than they would otherwise have been able to afford. Then, when housing prices dropped, the owners found that they were carrying loans that were larger than the value of their homes and were not able to refinance to a fixed rate mortgage.

The Interest-only mortgage is best for a savvy investor who is an informed risk taker and is not getting in over his or her head. The interest-only loan is not for a regular person just trying to get a larger mortgage. Chances are good that if you can't afford that house through any other means, you should stay away from an interest-only mortgage and consider a more affordable home.

Published on January 26, 2011