Homebuyers feeling blindsided by escalating financing costs might be tempted to explore unconventional home loans known as interest-only mortgages, which have much lower initial payments compared to a standard mortgage.
But these loans have a few major downsides potential borrowers should know about too.
With an interest-only mortgage, you initially only pay the interest on the loan, typically in the first five or 10 years. The advantage is that these initial payments are cheaper since you’re not obligated to make payments on the total amount borrowed, known as the principal.
After the initial interest-only period is over, you start paying the principal and interest for the remainder of the loan term. Payment terms vary, but the interest rate typically resets to whatever the prevailing rate is at the time — which may have gone up. And with the principal now included, these payments can cost you double or triple what you initially paid on the loan, according to the Federal Deposit Insurance Corporation.
If payments become too expensive, borrowers can try to negotiate a longer term or refinance the loan with a cheaper mortgage rate, if it’s available. However, refinancing can still cost about 2% to 5% of the total loan, which could offset the savings of a lowered monthly premium.
Right now, interest-only mortgages are “becoming more popular,” says Shmuel Shayowitz, president of Approved Funding, a mortgage lending firm. He says that for some homebuyers it “helps bridge the gap with the monthly payment.”
But again, as Shayowitz points out, these types of loans have downsides every borrower should consider, even if they can temporarily save you a few hundred bucks a month.
First off, these loans typically charge higher interest rates than conventional mortgages. The lowered monthly cost only comes from kicking the principal payment down the road to a later date.
And because you are paying a higher interest rate, and making more payments on interest overall, you also will pay more in interest over time, compared to a conventional loan.
Also, there’s a risk that mortgage rates could rise over time, as has been the case recently. This would make the monthly payments more expensive than initially expected after the interest-only period ends. The burden of those added costs could put borrowers at risk of defaulting on the loan.
Rate hike increases are usually capped at about 2% after the initial interest-only period expires, but that can still be a significant expense.
Another risk is that if your home loses value, selling the property later may not cover the total cost of the loan.
“Think about why you’re considering it,” says Shayowitz. A bad candidate for an interest-only loan would be someone looking to “shave off a few dollars” of their monthly costs just to get into a home they may not qualify for otherwise.
A good candidate for this type of loan typically has a reliable source of income with enough cash flow to cover mortgage payments after the interest-only period expires. Mortgage rates could still rise, but the buyer would be willing to accept that risk, especially if they plan to sell the home within a few years. Choosing an interest-only mortgage would temporarily free up cash for other expenses or investments.
“So much of this boils down to putting pen to paper,” says Andy Darkins, a certified financial planner with wealth management firm Vista Capital Partners. He advises would-be buyers to do a “stress test” of their short- and long-term cash flow before considering an interest-only loan.
“Look at different scenarios,” he says. “At the end of the [interest-only] term, what if the payment doubled? And what if it fell somewhere in between that and your initial payments? Ask yourself if you could actually afford the payments in each of those circumstances.”
For homeowners looking to minimize monthly costs, another option to consider is a conventional adjustable-rate mortgage, which typically offer lower rates compared to fixed-rate home loans. Again, terms vary, but typically the interest rate for an adjustable mortgage will be locked in for an initial term of five, seven or 10 years, after which it’s reset every year, or even every month.
The advantage with an adjustable-rate mortgage is that, unlike interest-only loans, you’d actually start paying off the loan right away, building home equity that you can borrow from later, if needed. And you wouldn’t be saddling yourself with thousands of dollars of unnecessary interest charges, either.
Adjustable-rate mortgages still carry some risk, however, as mortgage rates might rise. That’s why home purchasers often stick with the cost-certainty offered by fixed-rate mortgages, even though the interest rate for this type of loan tends to be higher.
Read More:Pros and cons of interest-only mortgages