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Pros and Cons of Interest-Only Mortgage Payments

This article was written by in Debt Reduction. 9 comments.


Yesterday, Consumerism Commentary reader Ryan suggested I write about interest-only mortgages.

There is no such thing as an “interest-only mortgage.” Wouldn’t that be nice, though, to have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, when you become a borrower, your lender will insist upon receiving interest payments as well as principal at some point. What does exist, however, is an interest-only payment option for mortgages. The interest-only payment option can apply to adjustable-rate mortgages and fixed-rate mortgages alike. The purpose is to allow borrowers to reduce monthly payments for a period of time. Rather than a monthly payment of $1,200, in which $600 goes to interest and $600 goes to the principal, the monthly payment would only be $600.

The lower monthly payments during the interest-only period are good for households with irregular income such as commission payments less frequent than monthly, or households with unpredictable income, like that of a business owner who is expecting low income while the business is in a period of growth.

Interest-only payment options also allow borrowers to “afford” a more expensive home. This can be important for an executive who needs to entertain clients at home and its appearance is crucial to career success, but there could be a strong desire to use the lower payments to buy a home beyond the means of the borrower.

This is a dangerous prospect, especially in an environment where we can’t be sure whether the value of the house will rise in the short term. While making interest-only payments, the borrower is not building equity in the house. if the borrower is not building equity, the concept is similar to renting, particularly if home values are stagnant or decline. The amount you owe on the mortgage will never decrease. Even worse, some interest-only payments don’t cover the full amount of interest due each month. The excess, non-paid interest would then be tacked onto the principal, causing the borrower to owe more in principal than the home was worth when purchased.

When house values are declining, like they have been in many areas of the United States, this problem is compounded. Not only does the borrower owe the full purchased value of the house while making the interest-only payments, but the house’s declining values means the borrower will quickly owe more than the home is worth. Then, if it is sold, the borrower could owe more money to the lender than he received in the sale.

Interest-only payment options don’t last forever. After the interest-only period ends, the lender will expect the borrower to start paying back the principal. This can result in a significant increase in the number written on the checks sent to the lender. If the income hasn’t increased as expected or if the business has not moved past the “growth” stage, the new payment — a larger payment than you would have had throughout the life of the mortgage if the interest-only option was not selected — might be unaffordable.

The Federal Reserve Board has a helpful comparison chart outlining the differences in payments you might expect if you choose an interest-only payment option, reproduced below. Notice how low the equity is in the last column, identifying borrowers who opt for the interest-only method.

Interest-only mortgage payment comparison

Do you have or have you had an interest-only payment option on a mortgage? Please share your experiences or opinions.

Updated June 20, 2014 and originally published June 3, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 9 comments… read them below or add one }

avatar Julie

We considered an interest-only loan at one point, just because the rate was lower that of a conventional fixed-rate mortgage so we could have made the same total payment but chipped away at more of the principal. In the end, though, we’re too risk-averse to rely even on ourselves to pay the extra every month even though we didn’t “have” to. We still pay extra now, but it fluctuates from month to month depending on our expenses.

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avatar Meg from FruWiki

As I understand it, interest-only mortgages are promoted as useful for people who don’t plan to keep their homes for a long time, e.g. flippers or people just planning to move in a few years. Since they plan to move before the payments go up, it does sort of make sense. However, a lot of people got stuck with a house they couldn’t sell and a mortgage they couldn’t afford.

Five years ago, my husband and I got a regular, fixed-rate mortgage on a house that was affordable and are happy we did so — especially since many of our friends pay more than we for apartments half the size (and we have 1/3 of an acre, too).

I remember a lot of the bad advice we were given, even by smart people close to us with “experience” in these sorts of things. For example: “Buy as much house as you can afford, because your income and house values will only go up.” And, likewise, “You can always refinance. Housing always goes up. They aren’t making any more land.” And there was so much said about building equity and “Your home is your best investment”, etc. It seems ridiculous, but lots of people said and believed those things! (And I hope they question them now!)

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avatar Ryan

Another possible benefit to the IO loan is it free money to pay down a second mortgage/HELOC/CC/student loans. I agree that there is risk involved; risk always should be considered.

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avatar Smith

We are about to close on a house and are using an interest only loan. We are very financially disciplined with no debt except our mortgage, which is at 4.75%, and we will be moving out of our house in 5 years. We have an emergency fund.

We just plan to “pay ourselves the principal.” Initially we are going to take half of the principal and invest in our IRAs, and keep the other half in CDs or just a savings account. If we see the housing market starts to level out or appreciate, we’ll probably shift more of that principal into higher risk investments. I still feel over the long term, i.e., 25-30 years, equities will beat 4.75% fairly handily.

I do agree that for the vast majority of Americans interest only loans are not wise decisions. However, with the fairly low rates, I think for some financially stable persons IO loans can be good tools. Sure there are

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avatar ctreit

I have a neighbor who has an interest only mortgage for 10 years. I think he and his wife decided on the interest only mortgage so that they could move into the house the wanted. They are very disciplined and aware of the various risks involved. For example, they have been paying back some of the principal to the same tune of a regular mortgage or even more. But when I last talked to him about the mortgage a few months ago, they had just stopped making these extra payments since they wanted to preserve cash. I thought this was a sensible choice at a time when the credit market froze up. They seem to make very rational financial decisions and really take advantage of the flexibility an interest only mortgage affords them. As for me, I would not want to go that way. I am very happy with my 30-year fixed mortgage on which I also make extra payments. I would also only recommend an interest only mortgage in very few cases.

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avatar Candide

I have a mortgage that’s IO for 10 years, then regular P&I for the last 20 years and is a fixed rate. The rationale is that while there’s no equity building in the house, in 10 years, our income will be appreciably higher, meaning that we can make the higher payments. Though we’re actually refinancing because rates dropped enough to lower our payment AND build equity. It’s worth noting that the equity built in the first few years of a mortgage, while real, is tiny, and that IO does beat renting because of the tax deduction.

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avatar Kevin

When I bought my home, I had no money to put down. I know that’s a horrible sign but the bank was fine with doing it. I didn’t want PMI if I could avoid it so the bank did an 80/20 loan. The 20% was IO for 10 years and then regular P&I for the remaining 20 years. And it is a fixed rate over the life of the loan.

I’ve set my bank to automatically over pay the interest only loan each month. It isn’t much but it is more than I would have been paying on that amount even if it was a standard loan. It is slowly going down and I plan on having it paid off before the interest only period runs out. If I change nothing, it will be 4 years and 2 months before the interest only period is over. But I do have the flexibility to reduce my payment if I run into tough times. I am really going to hammer it as long as I can because I am currently upside down in my house.

And that is the downside. I am upside down in my house. And it is by a fair amount right now. It is not a major issue because I am not planning on moving for a while. But if I lose my job, it could make things very hard. I think I wouldn’t have got my mortgage in today’s current market because of my debt to income ratio. It isn’t that I bought more house than I can afford… but with my student loans, I don’t have enough money coming in each month to really afford anything. But I am working on that too. And should be done with those and the 2nd mortgage in just under 5 years from now. Until that time, life is probably more stressful than it would be if I had made different choices. I am happy with my choices right now but they weren’t the easiest ones.

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avatar debtay

I opt for an IO loan and up to this point it has faired well for me. Each year I get a fairly large income tax check which I place more than half to the principle of the loan. It is my hope that when I reach my 10th year and it switches to I+P my efforts to reduce the loan amount will be worth it. The interesting thing about this is eveytime I make a principle payment the loan readjusts and my IO is reduced. Im not sure if the rates will go up 8 years from now but maybe I’d be able to refi at that time. That is the best I can do.

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avatar debtay

I opt for an IO loan and up to this point it has faired well for me. Each year I get a fairly large income tax check which I place more than half to the principle of the loan. It is my hope that when I reach my 10th year and it switches to I+P my efforts to reduce the loan amount will be worth it. The interesting thing about this is eveytime I make a principle payment the loan readjusts and my IO is reduced. Im not sure if the rates will go up 8 years from now but maybe I'd be able to refi at that time. That is the best I can do.

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