On the surface an interest only mortgage looks inviting. Throughout the term of the mortgage, the number of months you make payments, you only pay interest to your lender, rather than interest and principal, the way fixed and adjustable mortgages work. At the end of the term, you pay off the entire mortgage.
The benefit of this arrangement is a lower payment. While this might sound enticing, it’s not always the best route to take when planning your future. However, before we begin on the disadvantages of taking an interest only mortgage, let’s consider the advantages of an interest only mortgage.
When housing markets are soft, meaning it’s a buyer’s market and time to get bargains, some people aren’t quite in the position to buy a home. They may be financially more secure in a few months or a year but their income simply can’t handle the mortgage payment for the type of home they want. Alternatively, they find a huge bargain on a house that is slightly over their budget but know that the payment for a mortgage won’t be out of their reach in just a short time. Unfortunately, the house won’t stay on the market that long. Here, an interest only mortgage might make sense.
To solve the problem, they look to a way to lower their mortgage cost. One way is to take an interest only mortgage. On an interest only mortgage they can lower the monthly outlay since none of it goes into paying off the mortgage. This arrangement works well for those that are sure they’ll have money later either through a promotion or even an inheritance. An interest only mortgage is also good for another type of borrower.
The second type of borrower that benefits from an interest only mortgage is a person that purchases homes for resale. Since the sale of the home will pay off the mortgage, the lower monthly outlay of the interest only mortgage keeps his cash flow lower every month. This leaves more money for him to make improvements on the property and snatch up a higher profit.
The problems with an interest only mortgage come into play when there’s no concrete method of increasing income and the lower rate lures the buyer into purchase of an interest only mortgage. When the end of the term arrives, it’s time to pay the piper. At that time the homebuyer has to find a method to pay off the balance all at once.
Some methods of paying the balance include refinance or personal savings. In situations where the buyer is eligible for a traditional mortgage, he can refinance it with his bank or another and begin regular mortgage payments. Unlike the interest only mortgage payments, these pay down the principal. If he’s not eligible for another loan, then he has a severe problem and faces losing his house.
Alternatively, the buyer can start a side savings as soon as possible. The principal payments on mortgages are quite small and most of the money goes toward interest. Initially, if you put smaller amounts away every month, you can sometimes turn it into a larger amount by using a higher return investment vehicle, such as the stock market. However, higher returns come with risks and you might lose the money you intended to use to pay off the interest only mortgage.
No matter what route you take, if you choose an interest only mortgage, make certain that you have the money at the end to pay the principal. Before you sign on the dotted line for your interest only mortgage have a realistic plan. Your entire future is the outcome of the decisions you make today.
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