“Interest-only mortgage? That… doesn’t sound like it makes sense.”
If you are familiar with traditional mortgages, this is probably what’s running through your head right now. Understandably, it causes a bit of confusion and almost sounds like an oxy-moron. After all, if there’s no principal to pay how are you going to make any progress paying down your mortgage month-to-month? You won’t; rather, you don’t have to pay the principal every month only the interest. It may not make a whole lot of sense, but believe it or not there are instances where an interest-only mortgage makes sense.
But first, let’s start at the very beginning.
What is an interest-only mortgage?
As stated, interest-only mortgages require the borrower to only pay the interest every month (with principal being optional) as the interest builds. These monthly payments are generally lower than traditional mortgages and are certainly attractive to first-time homebuyers. They sound fantastic, yet borrowers need to know that they must be disciplined in paying the principal. The principal isn’t going to pay itself – and it must be paid eventually. These loans are ‘interest-only’ for only a period of time; thus, borrowers need to have a plan of action regarding how often they are going to pay the principal and a baseline for how much they need to pay annually.
Why should a borrower choose this option?
For the borrower that is not in a hurry to pay the sum of their principal and is financially capable to pay the entire sum before the mortgage term is over, an interest-only mortgage is worth looking into. Allowing a first-time homeowner to ‘ease’ into home ownership, this option gives borrowers more breathing room to focus on other aspects of the home. Such as making repairs that could be costly later, furnishing the home, investing in lawn equipment, etc. It will also provide extra room for emergencies, such as a leaky septic tank the previous owners failed to mention during closing (hey, it happens). Home ownership can be expensive; this is a great way for new homeowners to give themselves a little extra ‘padding’ as they venture into this new and wild world.
When should a borrower avoid this option?
When building equity is important. Unless a borrower is paying the principal regularly, the stake in the property will continue to flatline. Thus, building wealth into the property and borrowing against it in the future is a no-go. Additionally (and depending on the location of the property), the property could lose value over time. If the borrower is not paying principal regularly and decides to sell before they must start paying principal and interest, this could result in a loss on the home before the entire balance is paid off to begin with. From there, the borrower will have to pay out of pocket. It goes right back around to the borrower needing to be disciplined in their principal payments: while it seems like an inexpensive mortgage option, it can ultimately become a costly decision if one is not careful.
I want to start a business – is an interest-only mortgage right for me?
The easy answer is, ‘possibly.’ Interest-only mortgages are ideal for a business that has little capital and/or is just starting their business and needs their payments to be as little as possible. This allows the business to invest into their property early and increases the chances that their commercial property will be profitable (that’s what lenders love to hear). However, borrowers must keep in mind that if the principal has not been paid regularly, they will face a higher-than-normal payment once the mortgage transitions from being ‘interest-only’ to including mandatory principal payments. Therefore, business owners must use this type of loan to grow their business early to ensure they do not default.
If there is one attribute every borrower must have when choosing an interest-only mortgage, it’s this: responsibility. It isn’t enough to merely make your payments on time. You have to know when the principal will be due, how much time you have until the principal payments are mandatory, and how much you should be paying before they are mandatory to ensure you are not hit with a much higher, regular monthly payment that you didn’t anticipate. They are a double-edged sword, but by knowing how to use them strategically they can give borrowers a little extra room to ensure they succeed financially.