You generally must pay principal and interest on a mortgage each month, unless you obtain an interest-only loan. The option to pay interest only can come in handy when money is tight, but it effectively defers principal payments for later on, which can be risky. Your mortgage lender should advise you on the specific features, benefits and risks of a particular interest-only loan.
Perks of Interest-Only Loans
You might seek out an interest-only loan program when buying or refinancing a house to keep your monthly payments as low as possible. With an interest-only loan, the lender sets a maximum time frame during which you can forgo principal payments. You know upon originating the loan, when you are scheduled to begin repaying principal -- there are no surprises. You can also choose to pay principal whenever you want on an interest-only plan. Should you have the resources to make more than the interest-only payment, any surplus amount may be applied toward the loan's principal balance. Otherwise, pay only the interest each month that's stated on your mortgage coupon to stay current on your loan.
Pitfalls of Paying Interest only
Putting off principal repayment can be dangerous, especially if your income doesn't increase by the end of the interest-only period. Your payments will inevitably be higher, as you must pay interest plus principal for the remainder of the repayment term. Although the lender discloses this at loan origination and provides a schedule of all future payments for the following 15 or 30 years, the additional principal payment can still come as a shock to some borrowers. If you can't afford to make the full payments when the interest-only period ends, you may find yourself having to refinance or sell to get out of your loan.
Many Kinds of Interest-Only Mortgages
Lenders typically offer interest-only periods of three to 10 years. However, there are many variations of interest-only programs. For example, you can get a 30-year fixed-rate mortgage with a 5-year interest-only period. Or you can opt for a slightly more complex loan, such as a 30-year adjustable-rate mortgage that has a fixed interest rate for five years, after which the rate increases at specified intervals for the remaining 25 years. On this type of interest-only ARM, the interest-only period usually lasts the length of the fixed-rate period or longer.
Making interest-only payments for several years puts only a small dent in your principal balance. If your interest-only loan comes with a balloon-payment feature, you will have to make an immense payment just a few years after your interest-only period ends. A balloon payment is a single large payment that comes due at the end of the repayment term. It allows your monthly payments to be spread out, or amortized, over a longer period than the repayment term, effectively allowing for lower payments. For example, a 15-year loan with a 10-year interest-only period is amortized over 30 years, but must be paid off in 15 years. The final payment needed to pay off the principal balance will be tens of thousands of dollars to hundreds of thousands of dollars, depending on the initial loan size. Borrowers typically get these loans with the intention of selling or refinancing before the balloon payment is due.