Mortgage lenders, although only a small number of them, are offering interest-only mortgage loans again. If you’re ready to finance a home, should you consider one?
Maybe. But only if you fully understand how these loans work and the risks that come with them.
Interest-only loans can be attractive because the payments you make during the early years of your loan, during the interest-only period, will be lower than what they would be with a traditional fixed-rate or adjustable-rate loan. But there’s a risk, too: After the interest-only portion ends, your monthly mortgage payment will jump, sometimes by hundreds of dollars.
And if your home hasn’t increased in value during the interest-only period, you might struggle to refinance your interest-only loan into a standard mortgage, which is a big problem if your new monthly payment is too high for you to afford.
Because of this, mortgage professionals say that interest-only mortgages are only a good choice for a small number of homeowners, those who are financially savvy enough to invest the savings they earn and know they can afford the eventual higher monthly payments if they can’t refinance or sell.
The underwater problem
Borrowers need to know, too, that if they take out an interest-only loan, they might not build any equity in their home. Even worse, if the value of their home does dip, they might end up after the interest-only period ends having a home that is worth less than what they owe on their mortgage, a condition known as being underwater.
"The biggest con is that you are not paying down your loan. The only equity you build on your home is from an increase in value," said Karen Lee, a certified financial planner in Atlanta. "As we experienced in 2008 and 2009, home values don't always rise, and sometimes even decline. The risk is going underwater on your home loan."
Interest-only loans are more complicated than standard fixed-rate or adjustable-rate mortgages. These loans feature an introductory period during which you only pay the interest on your loan, leaving your principal balance untouched. Say you take out a 30-year interest-only loan. You might make only interest payments during the first 10 years of the loan. After that interest-only period ends, you'll begin paying down your principal.
Your monthly payment, then, will be lower during the interest-only period because you are only paying for interest, property taxes and homeowners' insurance. After that period ends, your monthly payment will jump, sometimes by a lot, because you are now paying down your principal balance in addition to paying for interest, taxes and insurance.
The new monthly payment can sometimes be significantly higher because not only are you now paying off your principal balance, you are doing it over a shorter number of years. When you take out a 30-year, fixed-rate mortgage of $200,000, you pay down your principal balance over 30 years. When the 10-year interest-only period of a 30-year loan of $200,000 ends, you still have to pay down that $200,000. But you only have 20 years to do it, leaving you with higher monthly payments.
Than Merrill, real estate investor and chief executive officer of San Diego-based real estate education company FortuneBuilders, calls interest-only loans a "double-edged sword." He also said that because there is more risk with these loans, interest-only mortgage rates are sometimes higher than they are with standard loan products.
Interest-only loans can be especially problematic during down real estate markets. This happened before, of course, during the housing slump of 2007 and 2008. As Merrill says, if your home loses value and you aren't paying down the principal balance of your loan, you might find yourself owing more on your mortgage than what your home is currently worth.
Say you bought your home for $200,000. Instead of taking out a traditional mortgage, you choose an interest-only loan. During the first 10 years of this 30-year loan, you are only paying on your mortgage's interest, leaving its principal balance untouched. After 10 years, then, you'd still owe $200,000 on your loan.
Say after living in your home for five years, you decide to sell. Say, too, that during these five years, the value of your home has dropped. Maybe your residence is now worth just $180,000. If you still owe $200,000 because of the interest-only portion of your mortgage, you might have to write a check to your mortgage lender when you sell. It won't be easy to convince a buyer to pay more than your home's $180,000 market value.
"It may be easier for owners with interest-only loans to find themselves underwater," Merrill said.
On the plus side? Because your mortgage payments will be lower during the interest-only period, you might be able to buy a home that you otherwise couldn't afford with a standard fixed-rate or adjustable-rate mortgage, Merrill said.
You do have to be cautious, though. The key is to make sure that you can afford the new monthly mortgage payment that you'll face after the interest-only period ends.
You might decide when taking out an interest-only loan that you'll simply refinance your mortgage into a traditional fixed-rate or adjustable-rate loan before the interest-only period ends. This way, your new monthly payments won’t be quite as high. The problem with that? If your home loses value, you might struggle to refinance.
Mortgage lenders want you to have at least 20 percent equity in your home before approving you for a refinance. If your home loses value and you haven't paid off any of your principal balance, you won't have any equity, let alone 20 percent.
What if you decide that you are going to sell before the interest-only period ends? You’ll again face a challenge if your home’s value declines. Say your home is now worth $200,000 but you took out a $220,000 interest-only loan to buy it. If you haven't paid off any of your principal balance and you can only sell your home for $200,000, you will owe your lender for at least $20,000.
Then there are the unrealistic expectations borrowers often have when considering one of these loans. They might say they'll pay extra each month and devote those dollars to paying down at least some of their loan's principle balance. But said Corey Vandenberg, a mortgage banker in Lafayette, Indiana, said most homeowners never follow through on this promise.
"I have sat across from borrowers who told me they were going to pay extra, make double payments or pay $100 more every month," Vandenberg said. "When they came back for a refinance, 90 percent had not done so. It is too easy to just make the minimum payment, like with a credit card."
Understand the risks
Michael Mandis, founder of Alliance Mortgage Funding in Cockeysville, Maryland, said that borrowers should be wary of interest-only loans. There are positives with these loans. But they come with big risks, too, Mandis said.
For example, say a family has three teens and need a four-bedroom home. In their market they can only afford a two- or three-bedroom residence with a traditional fixed-rate or adjustable-rate loan. With an interest-only loan, this family might be able to get into that four-bedroom home with a monthly payment that is comparable to one they'd get for a two- to three-bedroom home with a fully amortizing loan.
The lower monthly payment might also result in a higher monthly cash flow, Mandis said. Owners can invest these savings in the hope of earning more from their dollars.
However, homeowners too often don't plan for the eventual increase when the interest-only period ends, Mandis said.
"Interest-only loans are very risky for the homeowner and only work for the most financially savvy borrowers," Mandis said. "My experience tells me that the cons of interest-only loans often outweigh the pros. It's the reason why I rarely offer them to my clients."
Who they might work for
Mandis said that interest-only loans could be a good fit for financially savvy borrowers who will invest the savings they receive from smaller loan payments into a vehicle the provides them with a higher return on investment.
An interest-only loan can also be helpful for owners who need to pay off credit card debt, Mandis said. This debt comes with interest rates that are far higher than the ones attached to mortgage loans. Borrowers can use the money they aren't spending on their monthly mortgage payment to pay down their credit cards, Mandis said.
Vandenberg added that borrowers who are expecting an influx of cash in the near future might take out an interest-only mortgage, too. They can then get into a more expensive home that they might not have been able to otherwise afford. They can make their lower monthly payments, while living in this nicer home, until their windfall of cash arrives. Once this cash boost comes in, homeowners can then pay more on their mortgage to start paying down its principal balance.
Finally, owners who expect to move in the near future might benefit from such a mortgage, too, Vandenberg said. Maybe your employer plans to relocate you in the next three to five years. You can use an interest-only mortgage to get into a pricier home and then sell before that interest-only period kicks in, he said.