What is an interest-only mortgage? At least an affordable home loan
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What is an interest-only mortgage? It is a type of home loan where you only pay the interest for a period of time first, followed by a period in which you pay back both the interest and the principal.
Most interest-only home loans are adjustable rate mortgages or ARMs, says Scott Sheldon, a senior loan officer and consumer advocate in Sonoma County, California.
An ARM, also known as a variable rate mortgage, is a loan that starts at a fixed, predetermined rate that is likely lower than what you would get on a comparable fixed rate mortgage. However, the interest rate adjusts after a certain initial period – usually three, five, seven or ten years – based on market indices.
As with a traditional ARM, an interest-only mortgage has a term – typically three, five, seven, or ten years – during which you only pay the interest accrued on that principal. But unlike a traditional ARM, borrowers with an interest-only mortgage do not build equity in their home.
“I would call it placeholder money,” says Sheldon. “You basically only get the value of being able to buy a home and your money is held until you make a payment to the client.”
Here’s what you need to know about the pros and cons of interest-only mortgages – and how to determine if one is right for you.
Benefits of an interest-only mortgage
Interest-only mortgages have a myriad of benefits that can help home buyers overcome the home hump.
Low monthly payments, at least initially: Since you only pay interest during the introductory phase of an interest-only loan, your monthly mortgage payments would be significantly lower than what you would pay on a traditional mortgage.
How deep do we talk
Let’s say you receive a $ 300,000 pure interest with an initial interest rate of 4% for five years. For five years, your pure interest payment would be $ 1,000 per month. Very cute!
However, after five years you will start paying back the principal – and since you likely have an ARM, let’s assume your interest rates adjust to 5%. Now your main monthly interest payment has increased to $ 1,754 per month. That’s a big step up, so all you know is that at some point you will have to pay the Piper on the street.
Improved cash flow: Since your monthly mortgage payments are significantly lower in the initial phase, you have more money in your bank account with an interest-only mortgage.
“That can be a big advantage, provided you are responsible for the money you save with the client,” says Sheldon.
For example, if you are using some of the money you’ve saved to pay off high-yield credit card debt, an interest-only mortgage can be a good financial management tool.
Disadvantages of a pure interest rate mortgage
Still, rate-linked mortgages also have some drawbacks:
Higher down payments: To protect the money borrowed, lenders who only offer interest-bearing loans often require borrowers to make higher down payments. Many lenders require a 25% down payment on an interest-only mortgage. That’s significantly more than what most borrowers have to pay for a conventional mortgage, which typically requires a minimum 5% down payment – although if you paid less than 20% for a conventional loan, you’d have to pay private mortgage insurance or PMI .
You also need a pretty good credit score – think 740 or higher, says Sheldon – to qualify for an interest-only mortgage.
Higher interest rates: Although mortgage rates can vary from lender to lender, the interest rates on interest-only loans are, on average, about 1.25% to 1.33% higher than a 30-year fixed loan, Sheldon says.
You do not build up equity: One of the best financial benefits of being a homeowner is that you can build equity in your home that you can later use to sell your home for a profit or by obtaining a home loan or home improvement line of credit. But that doesn’t happen in the early stages of an interest-only loan. Essentially, you will be making mortgage payments, but you will not be reducing your mortgage debt.
Borrowers, on the other hand, have the option to repay the principal at any time, which would lower their monthly mortgage payments and also help build equity.
Should you take out an interest-only mortgage? How do you say?
While straight-rate mortgages can be risky for many homebuyers, in certain circumstances they are good. Here are some types of borrowers who could benefit from an interest-only loan:
- Lower mortgage payments for a while. When you need lower mortgage payments, an interest-only loan is the bill.
- You are planning to move or downsize. Ideally before the end of the interest period. In the meantime, someone planning to buy a home they will grow old in shouldn’t think about an interest-only loan.
- Your income varies. If your income fluctuates from month to month, an interest-only mortgage can be a good option. “If you’re a real estate investor or stockbroker with fluctuating income, or are a self-employed contractor or entrepreneur with fluctuating income, you might be well suited for one of these loans,” says Sheldon.
- You can make a large mortgage payment before the initial phase ends. This allows you to gain a significant portion of the equity before the interest rate increases.
* Content Originally published by REALTOR.com, provided by PAAR **
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