In an interest only mortgage, the borrower is only required to pay the interest for a set period, and the principal balance remains sound. When the interest-only period ends, the borrower typically has several options, including paying off the loan balance in full or reorganizing the loan, such as converting it to a traditional mortgage or refinancing it.
Understanding How Interest Only Mortgages Works:
An interest only mortgage allows borrowers to make payments that cover only the interest collected on the loan for a specified period, basically extending from 5 years to 10 years. During this initial phase, borrowers do not have to pay down the principal amount of the loan, so their monthly payments are lower compared to a traditional mortgage.
Example, let’s say you take out a $100,000 interest-only mortgage with a 10% interest rate for a 20-year period. Your monthly payment would be calculated based on the interest that emerges from your $100,000 principal amount, as it will result in lower monthly payments, in comparison to a mortgage where you have to pay on your principal amount as well.
After the interest-only period ends, borrowers normally convert to a traditional mortgage scheme, where you have to pay both the principal and interest amount.
It’s noteworthy that while IOM offers lower initial payments, they are generally over burdened with risks and observation.
For example, borrowers may have to give higher payments once the interest-only period ends, which will lead to payment shock, since the principal amount does not decrease during your interest-only period, borrowers may not make equity as it is the case with the traditional mortgage option.
Comprehensively, interest-only mortgages can be useful for such borrowers, those who have an irregular income or those investors who are looking to maximise cash flow.
Who gets Benefited From Interest Only Mortgage?
- First Time Home Buyers- As interest only mortgage allow borrowers to defer large payments towards future years, when they anticipate their incomes to increase.
- Real Estate Investors: Those who want to earn more from their rental properties or undertake short-term investment strategies, it allows them to move funds towards property improvement.
- Borrowers with Irregular Income: Individuals with irregular income source, may find interest-only mortgages advantageous, as it can help manage cash flow fluctuations more efficiently.
- Planning for Future Income Growth: Borrowers expecting income increase in the future may choose IOMs to afford larger properties or investments.
- Short-Term Financing Needs: Interest only mortgage is suitable for short-term financing needs, such as bridge loans or situations where borrowers plan to sell the property.
Advantages and Disadvantages of Interest Only Mortgage
Advantages
- It Boost’s Cash Flow: Opting for an interest-only mortgage is a good choice for those who are looking to preserve higher cash flow in the middle of rising interest rates and tightening profit margins.
- Help in Expanding Opportunities: While initial payments remain modest, they will escalate notably in the future which will help investors to pursue larger property acquisitions.
- Accelerating Loan Repayment: Many interest-only mortgages allow unrestricted additional payments of principal amount. This option empowers borrowers to pay off the loan balance within the timeline.
- Suitable for Short-Term Financing: Similar to bridge loans or fix-and-flip ventures are beneficial for properties intended for sale within the initial years of acquisition.
- Lower payments: It proves to be a good option of lower payments for those who are looking for interest payment in the long term.
- Longer term mortgage: With this mortgage option you are allowed to pay interest in the long term.
Disadvantage
- Higher interest rates: Higher interest leads to higher monthly payments.
- Risk of increase in interest rates: This will only result in making monthly payments more expensive.
- Risk of loan default: Added costs on payments of interest can lead to loan default.
- Lower outcome: In case if your house lost a significant amount of its value due to any unforeseen circumstances, it will only lead to lower price for your house and which may not even cover the total cost of the loan itself.
Risks and Considerations Associated with Interest Only Mortgages
1. Higher Long-Term Costs: Interest-only mortgages may offer lower initial payments, borrowers end up paying more in interest over the tenure of the loan in comparison to traditional mortgage options.
2. Potential Payment Shock: Once the interest-only period ends, borrowers have to start making payments that include both principal and interest amount.
3. Limited Equity Build-Up: Since borrowers are not paying off the principal during the interest-only period, they may not build equity in their homes as quickly as they would have built if they had chosen the traditional mortgage. This can limit their ability to access home equity.
4. Qualification Challenges: Interest only mortgage may need strict qualification, such as higher credit scores and larger down payments, making them less accessible or less popular options to some borrowers.
5. Uncertain Future Income: Borrowers who opt for IOM based on expectations of future income growth or investment returns may face challenges if their income doesn’t increase as expected.
6. Refinancing Risk: If borrowers plan to refinance their interest-only mortgage once the interest-only period ends, they may face challenges if interest rates have risen or their financial situation has changed.
Is Interest Only Mortgage a Right Choice?
1. Assess Your Financial Goals: Consider your short-term and long-term financial objectives. If you are looking to maximize cash flow in the short term, or to invest in other opportunities, or planning for future income growth, interest only mortgage can be beneficial.
2. Evaluate Financial Situation: Review your current financial situation. Assess whether you have sufficient cash flow to cover sudden payment rise when the interest-only period ends.
3. Consider Risk Tolerance: Evaluate your risk tolerance and ability to withstand potential fluctuations in interest rates, property values, and income.
4. Review Market Conditions: Consider prevailing interest rates, housing market conditions, and economic trends and assess how changes in interest rates can hinder your ability to afford the mortgage payments.
5. Compare Loan Options: Compare IOM with traditional fixed-rate mortgages and other loan options. Examine the advantages and disadvantages of each type of Mortgage.
6. Seek Professional Advice: Consult with a financial advisor, mortgage broker, or real estate professional to get expert guidance on whether an interest-only mortgage is suitable for your individual circumstances.
By carefully evaluating these factors and seeking professional advice, you can determine whether an interest-only mortgage is the right choice for your financial situation and can lead towards your goals. It’s essential to weigh the potential benefits against the risks and ensure that the loan aligns with your long-term financial well-being.
Comparison in interest only mortgage and conventional mortgage
For the conventional mortgage, the borrower pays $1,520 per month from the start, covering both principal and interest throughout the term.
The principal balance remains unchanged during the interest-only period for the, while it decreases gradually with each payment for the conventional mortgage interest-only mortgage
Lets see an example, for the interest only mortgage during the first 10 years, the borrower pays $1,125 per month, covering only the interest. After the interest-only period, the monthly payment increases to $2,130 to cover both principal and interest.
| Aspect | IOM | Conventional mortgage |
| Initial interest rate | 4.5% | 4.5% |
| Loan amount | $300,000 | $300,000 |
| Loan term | 30 | 30 |
| Interest only period | 10 | NA (stars with principal and interest payments) |
| Monthly payment (initially) | $ 1,125 | $1,520 |
| Interest payment after IO period | $2,130 (principal and interest) | $1,520 ( remain constant) |
| Total interest payed | $279,000 | $247,220 |
| Total payments | $579,000 | $547,220 |
| Principal paid | $300,000 | $300,000 |
Commercial Mortgages
Interest only mortgage is the most preferred option while going for commercial mortgages. As real estate properties often require renovation after-purchase. It’s logical to seek a smaller mortgage payment initially to bear renovation expenses. Once renovations are complete, the property’s cash flow usually improves, ensuring no doubt about its ability to cover larger mortgage payments thereafter.
Conclusion
To conclude, we can say that interest only mortgage is beneficial for a certain class of borrowers. You can seek our Professional advice at DwellingIQ, we can help you make sound and aligned choices towards long-term financial goals.
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