What Is An Interest Only Mortgage, And Should I Get One? 

A new type of non-traditional home mortgage loan is now available to consumers.  It is known as an interest only mortgage loan. (This mortgage is sometimes called an Interest First mortgage.)   An interest only mortgage is exactly what the name implies.  For a part of the term of the mortgage, the borrower is paying only the interest that is due on the home mortgage loan and is not paying anything back towards the original principal balance. 

There are two types of these mortgages.  The first is interest only for an initial time period of 3, 5, 7 or 10 years.  At the end of the initial term, the mortgage then reverts to a traditional mortgage with payments of principal and interest amortized to a term of 30 years when the interest only initial period is included. 

The other type of interest only is a feature or option that is available in an Option ARM mortgages.  The option ARM offers, depending on the investor, three or four options for making payments.  Interest only is normally one of the options available.  However, the option ARM's can revert to standard payments of principal and interest based upon criteria other than a fixed time period.  The option ARM's generally have provisions for negative amortization (where unpaid interest is added to the unpaid principal balance) and will recast there payment schedule when certain criteria is met. 

Why an Interest Only Mortgage Loan Sounds Attractive 

Obviously, we would all like our monthly mortgage payments to be as low as possible.  With an interest only home mortgage loan, the borrower is keeping his monthly payments to a minimal by paying only the interest that was accrued on the loan in the thirty days since his last payment.  Therefore, this type of mortgage is often marketed to the consumer as a tool which allows the borrower to “buy more of a home” than they would be able to afford with a traditional home mortgage loan. 

To illustrate this let’s take a look at the purchase of a home with a $200,000 loan.  Buying this home with a traditional 30 year mortgage with a 6.0% interest rate would give you monthly mortgage payments (excluding taxes and insurance) of approximately $1,200.   On the other hand, if the consumer chooses an interest only 30 year mortgage at 6.125% (interest only loans are typically priced at 1/8% to 1/4% higher interest rate), the monthly mortgage payments would only be $1021.  . 

For the most part; however, financial advisors will tell you it is best not to choose this type of loan except in rare circumstances.  It is generally accepted that an interest only home mortgage loan is an alright choice if you don’t intend to hold the loan for more than two to four years and you have at least 20% equity in your home. 

Why An Interest Only Mortgage Is Not A Good Idea 

In general, it’s best not to choose an interest only option for your home mortgage loan.  Why?  The largest problem with this type of financing is that the home owner is not building any equity into his home with an interest only mortgage.  The home will still be considered “fully financed” until the initial period is over.