You think now is the right time for you to buy a house. Unfortunately, you don’t quite make enough money to handle the payments on your dream home. Your loan officer comes to you with a solution: an interest-only mortgage.
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With much lower payments, you can afford the mortgage. Yes, you’ll have to start paying on the principal at some point. But by then you’ll be making more money. Besides, you can always refinance to a new loan before the higher payments kick in.
It sounds perfect, but things don’t always go according to plan. In fact, some mortgage experts warn against the dangers of interest-only mortgages. Before you jump into an interest-only mortgage, make sure you understand what you’re getting into. Read on to find out why you could be putting your finances at risk with an interest-only home loan:
How do interest-only mortgages work?
With a regular mortgage, a borrower’s monthly payment goes to reduce the original balance of the loan (the principal), as well as going toward paying interest.
With interest-only mortgages, borrowers start out by paying only the interest charges associated with the loan. “The principal balance does not decrease, and the borrower only builds equity in the home through house [price] appreciation,” said Edward Seiler, chief housing economist with advisory firm Summit, LLC.
An interest-only period is usually five or 10 years, and once it’s over, the borrower has to start making payments on the principal as well. On a 30-year loan with a 10-year interest-only period, that leaves 20 years to pay off the entire principal.
When choosing such a mortgage, it’s important to know the risks. There’s a good chance you should run the opposite direction.
Risks of interest-only mortgages
The biggest risk of an interest-only mortgage, said Seiler, is you are likely to come to the end of the interest-only period unable to make the higher payments.
Casey Fleming, a long-time mortgage broker and author of The Loan Guide, uses the example in the table below to illustrate the change in payment at the end of a 10-year interest-only period:
As you can see, the payment almost doubles at the end of the interest-only period. Plus, the balance of the loan hasn’t gone down at all because you’ve only paid the financing charges.
Fleming pointed out that often the mortgage rate is fixed during the interest-only period. However, many interest-only mortgages become adjustable-rate mortgages at the end of that period. When that happens, the loan payment can become even less affordable if mortgage rates have increased.
In fact, Seiler said, interest-only mortgages played a role in the mortgage market collapse that led to the 2008-09 financial meltdown.
“Interest-only loans were abused leading up to the housing crisis,” he said. “They were used to buy homes beyond what borrowers could really afford.”
“They were, in many cases, ticking time bombs that led to unaffordable payment increases,” Seiler said. “In the case of adjustable-rate loans, there were even extra payment shocks that pushed many into default.”
If you haven’t managed to increase your income by the time the interest-only period ends, you won’t be able to pay the mortgage. On top of that, since you haven’t paid down any of your principal, refinancing might not be an option. “Refinancing your interest-only mortgage only works if your home has appreciated enough so that its value is high enough so a lender will give you a new loan,” said Fleming.
Why do people choose interest-only mortgages?
So, with the risks in mind, why do people decide to borrower using these types of loans?
Psychology plays a role. According to research, humans tend to overestimate the likelihood of positive events in the future. This is called “optimism bias.” We think good things will happen later and underestimate that chance that negative events will impact us.
Borrowers who want to get more house for their money believe that they will be able to handle the “real” payments down the road.
“Interest-only loans may be a great way to afford more home if a borrower expects their income to increase over time, and if the risk of house price depreciation is negligible,” said Seiler. And, due to optimism bias, borrowers think this perfect scenario applies to them.
The reality that few borrowers benefit from interest-only mortgages. It’s possible to make an interest-only mortgage work if you have irregular income and want to establish a lower minimum payment. Additionally, if you plan to flip a house, an interest-only mortgage can keep your monthly costs low until you sell the house. By and large, it’s important to consider your situation before you move forward carefully.
Don’t gamble with your mortgage
For the most part, both Fleming and Seiler counseled against interest-only mortgages.
They said that, even though these mortgage products can work out for some people, most borrowers only find themselves struggling once the interest-only period is over — especially if the end of that period coincides with falling home values.
Fleming said most borrowers are better off waiting until they can afford the payments on the house they want, or moderating their wishes and settling for a house they can afford.
Seiler agreed. “Borrowers should not use speculative products like interest-only loans,” he said. “This is essentially gambling. House prices may fall, and incomes do not necessarily rise.”