Regular mortgage: Payments pay off interest and a portion of the principal. Payments are $615.72 a month.
Sounds like quite a deal, right? However, potential borrowers must remember that while paying only interest, the principal does not go down, and no equity is built. So after five years, payments will increase, and no equity has been gained.
Fluctuating incomes. If income comes primarily from commissions or bonuses that occur in some months and not others, interest-only mortgages may help. Borrowers can pay only the interest when finances are tight, and pay interest plus principal when they have more money.
Expectations of earning more. If income is likely to rise substantially in the next few years, an interest-only mortgage may save borrowers money when they need it.
Desires to buy more house. Many first-time borrowers usually begin with a starter house, and then move into a dream home when income increases. With an interest-only mortgage, borrowers can afford more house now, and avoid transaction and moving costs.
Committed investors. If borrowers are committed and prepared to invest the money they save, interest-only mortgages can be a valid method of growing wealth. Additionally, buyers prepared to use the extra cash for home improvements, college funds, and retirement may also see benefit. The key is sticking with the investment plan.
For all these borrowers, the benefits of paying smaller monthly payments consisting only of interest may outweigh the risks. For others, however, the venture may be more risky than smart. How?
Increased monthly payments after the interest-free period. Think of it -- in a typical mortgage that pays both principal and interest, you are spreading the principal over 30 years. If you pay interest only for 5 years, once that period is over the principal is spread over 25 years. Thus, higher payments.
Higher interest rates. Many borrowers think interest-only mortgages have lower interest rates, but interest only mortgage rates are usually higher.
Market risks. The market for houses may always result in dropping prices rather than increased prices. This may mean difficulty selling at the end of your interest-only period, or a potential to owe money. In addition, market fluctuations may mean any investments you make with extra money saved could lose money rather than earn.
Temptation. Many people tell themselves they will invest the money they save, but often get tempted by vacations, lifestyle additions, and more.
No equity. After the period of interest-free payments, you will have no equity in your home if you have not paid any principal. Effectively, you've been renting.