Mortgage Loans - When Are Interest Only Mortgages Appropriate?

If this would burn a hole in your pocket - an interest-only loan may not be right for you.
If this would burn a hole in your pocket - an interest-only loan may not be right for you.

When can interest only loans be interesting.

Interest only mortgages can be an ideal tool if you understand their benefit. However, interest only mortgages are not for everyone. Interest only mortgages allow the borrower to pay only the loan's interest each month for a period of time without having to pay anything towards the loan's principal. Usually this is for a period of 5 to 10 years, after which time the payments include principal and interest similar to a fixed rate mortgage. During the period of interest only mortgage payments, the borrower has an option to also pay "extra" that can go towards the principal at their discretion. Because of these unique features, interest only mortgages are useful for some situations.

Investment Situations

  • Access to Investment Monies - One advantage of interest only mortgages is allowing better investment opportunities. Money saved by paying only the interest on the loan can be used for cash investments. There are two important aspects in this consideration. First you must be disciplined enough to use the extra money for investments rather than spending. Secondly, the investment rate of return does not have to be greater than the mortgage rate for this to make sense. While this may sound a little counter-intuitive, it does make sense under certain circumstances. For example, if you are being charged 7% but only earning 5%, it can still be a smart move if you are doing this on-purpose to build up your emergency cash fund in the short term. The fact that you are losing 2% today can take a back seat to the fact that you have little funds in the bank and this loan is helping you build savings quickly.
  • Real Estate Capital Gains - For individuals who are interested in utilizing the real estate market for investments, interest only mortgages can be ideal in appreciating real estate markets to keep your costs low but still reap the benefits of real estate appreciation. For instance, one may purchase a home for a short term period (maybe 2 years or more) and pay interest only knowing the appreciation of the real estate will exceed the mortgage rate. After a period of time, they then sell the home at the higher appreciated value. Even though it has cost them the interest payments on the loan over the time they owned the home, the profits from the sale well exceed these costs. Interest only mortgages therefore allow them to invest as little as possible to gain the profits in these attractive markets.

Special Income Situations

  • Fluctuating Income - For some people, interest only mortgages provide some degree of security to them because their income is erratic. Maybe this is because of seasonal variations in their jobs, or for the nature of their business in general. What an interest only mortgage allows is the lowest monthly payment so when income is lower, payments can still be made with ease. However, when income increases an additional amount can be awarded toward the principal thus reducing the overall loan amount. Interest only mortgages provide added security in this situation.
  • Stair Stepping Homes - For some families, they may choose an interest only mortgage in order to obtain "more" of a home to begin with rather than buying a starter home at first only to be faced with another sell and purchase a few years later. Even though purchasing a more expensive home initially may be financially constraining, it may be better in the long run if the costs of a second purchase a few years later can be avoided. Likewise, anticipated increases in income in a few years may justify this type of loan as well. By paying interest only initially, a family can purchase a larger home that will meet more of their long term needs.
  • Distributing Cash Toward a Second Mortgage - Another special situation can exist where two mortgages are needed on a home. In this situation, the larger mortgage can be an interest only mortgage which will allow a lower payment. Then, the additional money that would have gone toward the principal on the first mortgage can instead be applied to paying off the second mortgage faster (which is likely at a higher rate). This effectively can eliminate the second mortgage and also the need for private mortgage insurance as quick as possible.

While interest only mortgages are not for everyone, there are some situations where the money saved in the mortgage payment each month can be used in more effective ways. The important concept is that you must be disciplined enough to use the extra money saved to accomplish your financial goals rather than simply spending the savings frivolously. While paying only interest on your mortgage loan, nothing is going to reducing the principal of the loan itself. That means unless your home is appreciating, you are not gaining any equity in your home. If you have any questions about interest only mortgages, be sure to speak with your mortgage broker.

Interesting take on solutions to current issues.


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