Interest-Only Mortgage
Candlefocus EditorTypically, an interest-only mortgage is structured as an adjustable-rate mortgage (ARM). An ARM ties the interest rate on a loan to a specific financial index, such as the Prime Rate or the London Inter-Bank Offer Rate (LIBOR). As the interest rate of the ARM changes, the interest-only payments will also change. During the initial period of the ARM, the rate is kept the same and fixed for the length of the mortgage term.
The benefit of an interest-only mortgage is that payments are much lower than a conventional loan during the initial period of the loan. For example, a $400,000 mortgage loan with an 8% rate will require a payment of $2,766.86 per month with principal and interest. That same loan on an interest-only basis will require a payment of only $2,000 a month. The borrower will have the flexibility to invest the additional money and use the income to pay down the loan faster.
However, the downside of this type of loan is that it does not build equity or reduce the principal. When the interest-only period ends, the borrower will have to begin making payments with both principal and interest. The payment will increase significantly, as the payment on the $400,000 loan with an 8% rate with both principal and interest would be $3,265.19 per month. Additionally, because interest-only mortgages are often ARMs, you may have to refinance or modify your loan before the interest-only period ends.
Ultimately, an interest-only loan is an attractive option for those who can afford to pay their mortgage payments at the end of the term, as the short-term savings can be substantial. However, borrowers should take great care to understand the terms of the mortgage so that they understand the full financial implications of taking on an interest-only loan.