An interest-only mortgage is not a specific type of mortgage. It is an option that can be added to a mortgage loan that allows you to pay only the interest on the loan for a specified time period, usually five or 10 years. Borrowers sometimes find this option attractive because it requires lower mortgage payments during the interest-only period than a comparable loan without this option. However, an interest-only loan can pose several dangers.
Buying More than You Can Afford
Because an interest-only option on a mortgage allows you to make lower mortgage payments during the interest-only period, it may cause you to become overly optimistic about your ability to manage payments over the life of your mortgage. You might begin looking for a more expensive home, reasoning that your income will increase before the interest-only period ends. If your income does not increase as expected, this can make meeting your mortgage obligations difficult when you have to start paying both principal and interest.
Higher Future Mortgage Payments
The option to pay only the interest during the first years of your mortgage loan comes at a price -- when the interest-only period ends, your payments will be higher than if you had paid both principal and interest from loan inception. This is because after the interest-only period ends, you will have a shorter period of time to pay the principal balance of the loan. For example, if you take out a 30-year mortgage loan for $200,000 with a 10-year interest-only option, you will have to pay the $200,000 in principal over 20 years instead of 30 years.
Selling the Home
If you have to move for marriage, work or other life event, you will likely need to sell your home. If you cannot command a selling price high enough to cover your principal balance and selling costs, you will realize a loss from the sale. With an interest-only mortgage, your principal balance will be exactly the same at the end of the interest-only period as at loan inception. The lack of equity in your home during the interest-only period can make it difficult to sell the home without incurring a loss.
Renting the Home
If you need to move and cannot sell your home, you may consider renting the property to tenants to cover your mortgage payments on the home. During the interest-only period, you may be able to command rent high enough to cover your mortgage costs; however, after the interest-only period ends, you will have to raise the rent on your property to cover your higher payments. If you cannot find tenants willing to pay the higher rent amount, you will have to let the property sit vacant or make up the difference between the rent payments you receive and your higher mortgage payment.
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