\As you explore your loan options you’ll hear about many different types of loans. Some will sound too good to be true, but that doesn’t always mean they are. One example is the interest-only loan program. This program offers many strengths and weaknesses depending on the situation. The better you understand the potential benefits and drawbacks of an interest-only loan, the better prepared you are to make informed decisions about your financial future.
What Are Interest-Only Loans?
As the name implies, an interest-only mortgage loan is one in which the monthly payments are for the interest of the loan only and do not touch the actual balance of the loan. The interest-only loan is usually a type of adjustable-rate mortgage (ARM) though some lenders will offer fixed-rate interest-only loans. They are not as common as adjustable-rate options, however.
With this particular type of mortgage, borrowers make the interest-only payments for several years – usually between one and five years though some go for seven and even 10 years. Once the introductory period ends, the loan converts into a standard adjustable-rate 30-year mortgage – minus the number of years already paid. For instance, if the interest-only term was seven years, the mortgage term would be an additional 23 for a total of 30.
Once upon a time, balloon payment requirements were common with these types of loan arrangements. Far too often, predatory lending practices made this impossible for homeowners to manage and most states have outlawed the process.
These types of loans may sound too good to be true, but they offer very specific benefits that can be instrumental in helping people to get into more expensive homes and, in some cases, pay their mortgages off earlier by applying all secondary payments to the principal only. This means you could, in theory, pay off the entire mortgage faster by putting 100 percent of your secondary payments toward the primary loan. This leaves less interest for you to pay the following month and more money to put toward the principal.
What’s so Great About Interest-Only Loans?
Interest-only loans offer quite a few benefits to the right borrowers. However, not all borrowers are good matches for the specific benefits these loans offer. It takes specific situations and personalities to gain the best possible benefit from interest-only loans. The following are among the top benefits of interest-only loans:
People Waiting to Sell Their Existing Homes
Once in a while, you find the home of your dreams before you’ve sold the home that was once the one of your dreams, or you’re relocating from work and can’t afford to wait until your existing home sells to purchase a new home. In these cases, interest-only loans give you time to continue making payments while waiting to sell your existing home while paying greatly reduced payments on your new home. This is one of the ideal situations in which to consider an interest-only mortgage for your home. You know that the equity in your former home will be sufficient to build instant equity in your new home and that you can refinance for more favorable terms later if desired.
People who Require Greater Repayment Flexibility
Some people purchase homes expecting to make changes. In some cases, the changes are costly and will require extra money in the budget to make them. Those planning to make changes right away often find that the interest-only option gives them the freedom to do so without breaking the budget. It also offers people anticipating changes in life circumstances, such as marriage, divorce, or bringing an aging parent into the fold, greater flexibility to adjust to a new financial reality by providing lower payments until the finances are settled and budgets are worked out.
Fix and Flip Investment Properties
These loans are for people who make investments in distressed, rundown properties and make improvements to the home in hopes of turning the home around for a quick profit. Most of the interest-only loans for these types of projects are no longer than one to three years and carry higher than average interest rates. However, they offer outstanding potential for ROI and no mortgage payments during the renovation stage of the project.
Most fix and flip investors want to flip (sell to someone for a higher price than they’ve put into the property) before the interest-only stage of the loan ends. It’s a relatively easy entry into the real estate investment realm. However, most investors must seek hard-money lenders for interest-only loans rather than going through traditional resources like banks and mortgage companies.
Interest-only mortgages are well-suited for house flipping as they offer additional time to deal with unexpected issues that arise during the renovation process as well. However, this is one of the least expensive ways to get involved with the “flipping” business and allows homeowners the greater number of options to pursue if things go sideways on the flip before it’s finished without making them feel pressured to sell at a loss so they can get out from beneath excessively high overhead costs associated with traditional mortgages.
People Seeking Jumbo Loans
Jumbo loans are loans that are greater than the standard conforming loan limits. They are often necessary for high demand areas that exceed maximum loan amounts established by the Federal Housing Agency. This gives borrowers a much smaller pool for financing the loan since it is ineligible for Fannie Mae or Freddie Mac programs. For most of the country, that involves loans for amounts greater than $484,350, though some areas, due to higher than average home costs, have higher limits.
Why would someone seeking a jumbo loan benefit from an interest-only mortgage? The answer is simple, if they are diligent about their intentions to pay toward the principal each month, they can build equity in the home and refinance or consider a streamlined loan once they have enough equity in their home, they can refinance for more favorable terms. This is often the case since jumbo loans also carry higher interest rates, require larger down payments, and often demand higher fees and closing costs than conforming loans.
Jumbo loan seekers often need exceptional credit to qualify at all, along with a relatively low debt-to-income ratio. Some lenders may also require proof of cash reserves to pay for as much as one year of your mortgage should something go wrong (job loss, illness, etc.) as additional protection for the lender.
What Are the Potential Considerations or Drawbacks to Interest-Only Loans?
Many consumers are unaware of a few key details about interest-only loans. Even if it was explained to them in “bank speak,” they don’t fully understand what they are getting into when diving into an interest-only loan. They only understand that the initial monthly payments are very attractive and may not even comprehend that this will only last for the honeymoon period, after which they will drastically increase unless the homeowners have been diligent and disciplined about applying payments toward the principal each month.
So, the first massive consideration from investing in interest-only mortgages is the potential sticker shock at the end of your introductory term. Whether it is one year, three years, five, seven, or 10 years into the term it might price you out of the house you’ve thought was yours all this time.
The other downside is that owners have no equity in the home at the end of that introductory period. That means if they need to sell their home to move, fund college for their kids, pay medical bills, or for any other reason, there’s no equity to cash out.
This can come as a huge, and completely unpleasant, surprise to people who have been paying on their homes for close to ten years and are now forced to sell because they can’t afford the monthly notes too. Owners must understand that if they do not invest money in the principal and not just toward the interest, they will have zero equity in their homes.
One of the more crippling potential considerations involves property values. It is possible, though rare, for homes to lose value over time. The neighborhood could crash, the market could crash, and the house could fall into a state of disrepair. When this happens, its value decreases leaving homeowners wildly underwater and unable to secure additional financing to help make their loans more manageable once the honeymoon phase is over.
One more consideration to keep in mind for interest-only loans is that they aren’t as widely available as they were before the “Great Recession.” It’s simple economics. Many borrowers lost their homes because they couldn’t afford their adjusted rate payments once the introductory periods were over for their homes. This left banks with a surplus of houses and not enough money to operate effectively. Many lenders have pulled out of the interest-only loan market completely and others that do aren’t very aggressive in their advertising, making them hard to get.
When Are Interest-Only Loans the Best Options?
Even with the many benefits borrowers can enjoy with the interest-only mortgage, the drawbacks are not inconsequential. This isn’t the right loan for everyone. Only the most disciplined borrowers find them to be beneficial, or those who only plan to keep their homes a very short while.
Even then, it is wise to crunch the numbers first and decide if this is the best financial move for you to make. That includes anticipating interest rate increases over the life of the loan. While it isn’t possible to ascertain the actual changes in interest rates over the life of the loan, you can crunch the numbers assuming the maximum interest rates to determine the overall affordability of the loan.
Working with a trusted financial advisor can help you determine if this is a cost-effective option for you or if it is the only option for you. The better you understand your financial reality today and if your grasp on your financial future is solid, the better able you will be to predict if this is a good fit for your current mortgage needs.
You also need to fully understand what your plans are for the home you’re purchasing. Are you intending to make major renovations and costly changes to the home in the initial years of ownership? The extra room in your budget can be instrumental in allowing you to do that. Plus, it could improve the value of the home giving you instant equity while still only paying the interest on the mortgage. Do your homework with a keen eye on the likely value of the results and avoid making costly changes that offer no net returns on either usability, personal preference for the family, or home value.
Homebuyers who take a cautious and realistic approach and understand their spending habits are the best matches for interest-only mortgage loans. Finding the right lender with the most favorable terms for your financial situation will help.