Interest Only
A new home buyer will notice that a traditional mortgage payment consists of two pieces, the principal balance (the money that you borrowed) and the interest on the principal balance. Most home loans are set up so that the borrower will make a payment towards both the interest and principal every month.
An interest only loan is a bit different. With this type of loan, the borrower does not pay down the principal balance of the loan, they are only paying the interest that has accumulated each month. So, for example, if you have borrowed $200,000 and only pay the interest that has accumulated every month for five years, at the end of that five years you will still owe $200,000. Most interest only loans give the option of paying the principal plus interest or only the interest for a certain term of the loan. If you have a 30-year loan, you will typically have an interest only option for the first five to seven years.
You might be thinking that this type of loan sounds risky and could have even been one of the factors attributing to the housing bubble collapsing in 2008, and you would be correct. For this reason, the interest only loan falls under the scrutiny of the Financial Protection Bureau and must meet Qualified Mortgage status. This means that lenders must make a good faith effort to confirm that the borrower is very likely to repay the loan and has met certain requirements to prove this.
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Advantages of Paying Interest Only
There are several reasons a homebuyer would consider this type of loan. Monthly payments are low during the interest only term, and this might allow the buyer to afford a larger house or diversify their money into other investments. Additionally, interest only loan payments are often completely tax deductible. Many times, a homebuyer who opts to start with this type of loan will look to refinance at a lower, fixed rate after the interest only term expires.
Drawbacks to this Type of Loan
This loan should be considered with caution. The obvious risk is that by paying interest only, you really are not paying off the mortgage and you are not investing equity into your home loan. Additionally, when you aren’t paying down the principal, the interest payments will remain the same every month. Whereas, when you pay money towards the principal of the loan, the monthly interest payments decrease over time as well.
