The Principal Facts of an Interest-Only Mortgage
By
Tanu Javeri
You are buying the house of your dreams with an interest-only
mortgage. You'll get a low mortgage payment, and you'll maximize your
tax deduction, all on your current income! Everything seems to be going
good. But have you really understood the concept of interest-only
mortgage and how it functions.
So What Is An Interest-Only Mortgage?
Well
it may break your bubble but there is no such thing as an interest-only
mortgage - because eventually you'll have to pay the loan principal
as well. In other words, with an interest-only mortgage loan, you pay
only the interest on the mortgage in monthly payments for a fixed term.
After the end of that term, usually five to seven years, you pay the
balance in a lump sum, or start paying off the principal. Net Net! What
you're really getting is an interest-only payment method which can be
combined with any type of traditional mortgage.
For What Types Of Borrowers Are Interest-Only Mortgages Suitable?
An
Interest only mortgage can be an excellent choice for some borrowers,
who have a valid use for a lower initial required payment. For most
homeowners, paying down mortgage debt is the most effective way to build
wealth. Nonetheless, some may build wealth more rapidly by investing
excess cash flow rather than paying down their mortgage. Of course for
this to hold true, their return on investment must exceed the mortgage
interest rate.
The interest only product was originally designed
for individuals whose income is cyclical. Borrowers with fluctuating
incomes may value the flexibility the IO mortgage gives them. When their
finances are tight, they can make the IO payment, and when they are
flush they can make a substantial payment to principal.
Financial
advisers don't recommend interest-only residential mortgage to regular
wage earners who take out moderate-size residential mortgage loans and
don't have a strategy for investing the savings.
An interest-only mortgage might be a good fit for:
- someone whose income is mostly in the form of infrequent commissions or bonuses;
- someone who expects to earn a lot more in a few years;
- someone who truly will invest the savings on the difference between
an interest-only mortgage and an amortizing mortgage, and who is
confident that the investments will make money.
Again, an interest only mortgage is not the right choice
for everyone, but it can be a very effective choice for some
individuals.
The Deception You should Watch Out For
By
remembering one critical fact the borrowers can save themselves against
most deceptions. If two mortgages are identical except that only one has
an interest-only option, lenders view that one as riskier. The reason
is that, after any period has elapsed, the loan with the IO option will
have a larger balance.
Deception 1:
An interest-only loan
carries a lower interest rate. Lenders usually charge a higher rate for
an identical loan with an interest-only option. Most interest-only loans
are adjustable rate mortgages (ARMs), and ARMs have lower rates than
fixed-rate mortgages (FRMs). ARMs with the IO option have lower rates
than FRMs because they are ARMs, not because they are IO.
Deception 2:
An
interest-only loan allows the borrower to avoid paying for mortgage
insurance. Any IO loans with down payments less than 20% that don't
carry mortgage insurance from a mortgage insurance company are being
insured by the lender. The borrower is paying the premium in the
interest rate rather than as an insurance premium.
Pitfalls of Interest-Only Mortgages - Risks a borrower should take into consideration
Interest-only
payment options began to be offered to the masses not as a way to
leverage their money, but rather as a way to borrow more money while not
increasing the monthly payment. In turn they are using this method to
be the high bidder, or to buy a somewhat larger home. Borrowers
employing this method aren't "cash-flow" or "income-leveraging"
borrowers. What they're doing is buying more debt.
One always has
to remember that with increased leverage comes increased risk. And if
you are a sophisticated investor, you should take into that as a
borrowers who "debt leverage" into a more expensive home, with a larger
mortgage, you are expecting that your income and the home both will
appreciate. That may not be a big gamble when homes are appreciating,
but it could certainly play differently in a down real estate market.
There
is a danger in not reducing the balance. If prices should fail to
increase during the interest-only period, and if you should find a need
to sell the home, you could potentially be on the hook for thousands of
dollars in sales costs which would need to be paid out of whatever
equity (in the form of the down payment) you started out with.
Let's
look at the more extreme side, prices actually decline during the
mortgage holding period. If you finds yourselves in that situation,
coupled with a low down payment, you could easily going "underwater" -- a
descriptive term that means you are selling the property for less than
the remaining balance of the mortgage.
Not only is house selling
for less, the borrowers - that is you - would be required to somehow
coming up with rest of the money to fulfill the mortgage balance as
well as any sales charges (commissions, inspections, etc).
Interest Rate Risk
Unfortunately,
most of the interest-only loans being made today feature only short
fixed interest periods, if any; some features adjustable rates which can
change each month. Thought the rates are low today, these low rates
will inevitably rise.
The Final Analysis
Interest-only
payments do have a place in the world, at least with the practical
users. There are borrowers who can utilize a mortgage with interest-only
payments to their fullest. However, it would require careful financial
planning on behalf of the borrower to avoid going underwater.
Don't
rule out interest-only mortgages. Consider its pro and cons to your
particular situation and the lender you would be working with. On the
hind side also remember to question yourself that interest-only
payments may be working for friends or family but does it work for you?
About The Author Tanu Javeri, a stay-at-home mother, is a freelance writer with many years of experience and a contributor to
www.super-mortgages.com
web site. She has written articles addressing a range of subjects from
finance to international travel to beauty & health care. She was
formerly a business journalist and a Senior Research Executive at AC
Nielsen. She has gained knowledge on international markets by the
exposure she got from residing in India, Africa and USA. Substantial
information on residential mortgages and related topics is available at
www.super-mortgages.com/Take-Over-Mortgage and
www.super-mortgages.com/Private-Mortgages. Note to webmasters: Above hyperlinks must be kept intact when this article is published in another website.
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