An interest-only mortgage is a mortgage where the borrower only pays interest on the loan for a select period. The principal is repaid either in a lump sum at a specified date or in subsequent payments.
Characteristics of an Interest-Only Mortgage
Interest-only mortgage loans are usually structured as a particular type of adjustable-rate mortgage (ARM), known as an interest-only ARM.
Because interest-only mortgages are typically structured as an ARM, the borrower pays interest at a fixed rate for a certain number of years (the introductory period), after which both principal and interest are paid, and the interest rate starts to adjust.
Fixed-rate interest-only mortgages are less common, however, and typically have a term of 30 years.
Mortgage amortization is the process of making payments that include varying amounts of interest and principal payments.
After the interest-only period of an ARM, the loan converts to a standard schedule (fully amortized), and the borrower’s payments increase to include both interest and a portion of the principal.
Although borrowers are not required to pay principal during the interest-only period, they are allowed to do so with most lenders.
Related: Understand Your Mortgage Amortization Schedule and Save Money
Advantages and Disadvantages of Interest-Only Mortgages
Interest-only mortgages are not ideal for all borrowers. However, they have specific benefits.
An interest-only mortgage can be beneficial because of the reduced payments in the early years of the loan. Suppose a homebuyer expects to earn more money in the next 5 – 10 years; in that case, an interest-only mortgage may be a useful tool to assist in purchasing a home earlier rather than later. The buyer can purchase a home using an interest-only loan and benefit from smaller initial payments, with larger payments in the future as earnings increase.
With an interest-only mortgage that has a lump sum payment, borrowers can benefit by saving at their own pace for a single larger payment applied to principal. This is helpful for borrowers with inconsistent income.
The most significant disadvantage of interest-only mortgages is that the home’s equity is not increasing during the interest-only period since the borrower is not paying down the principal. However, in a housing market where home prices are quickly rising, an interest-only mortgage can help a borrower purchase a home that quickly appreciates due to increasing prices.
Another disadvantage of interest-only loans is that the interest rate can be slightly higher than a fixed-rate mortgage. Therefore, borrowers should review whether the advantages of buying a home with an interest-only mortgage outweigh the higher interest rate.
Marimark Mortgage is based in Tampa, Florida, and serves the mortgage needs of homebuyers, homeowners, and investors in Florida, Virginia, and Pennsylvania.
We specialize in conventional home mortgages, FHA, VA, and USDA mortgage options, refinance loans, and reverse mortgages. We’ve worked extensively with cash-out refinancing and help clients to lower their monthly mortgage payments.
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