An interest-only mortgage can deliver low monthly payments for several years to cash-strapped homeowners, freeing up money for things like home improvement projects, student loans and paying off credit card debt. That may sound great in theory, but does it make sense for you? In this article, we’ll explain how interest-only mortgages work and what you need to know before you apply for one.
What Is an Interest-Only Mortgage?
An interest-only mortgage is a type of home loan by which the homeowner is only required to pay off the interest from the principal she borrowed. Since she is only paying the interest, these bills can remain consistent for some time. This can be helpful for first-time homebuyers who need to defer large payments until they’ve shored up more income. However, it’s important to keep in mind that interest-only mortgages do not last forever and at some point the homebuyer will be responsible for paying off the principal of the loan.
What Does an Interest-Only Mortgage Require?
In the first few years of an interest-only mortgage, you only are required to pay the interest portion of a home loan. This means years of rock-bottom mortgage payments. The interest-only portion of a home loan is for a fixed period of time, often five to seven years. Once the interest-only portion of a loan ends, your payments will increase — typically by a significant amount — so you can begin to pay down the principal of your loan.
Who Should Take Out an Interest-Only Mortgage?
An interest-only mortgage may be right for you if you expect a big salary increase in the next few years, say, after completing a professional degree. (Doctors, lawyers and other professionals may want to consider this type of home loan when they are finishing up advanced degrees and graduate programs.) By the time they complete their degrees, they will be earning high enough salaries to handle the increase in their mortgage payments when the interest-only portion ends.
If you don’t foresee a big increase in your salary in the next few years, you may want to choose a more traditional financing plan for your home loan, one that fits comfortably in your budget now and in the future.
Someone with a more fluctuating income may be tempted to take out an interest-only mortgage for the big break in mortgage payments in the first few years of the loan. But if you opt for this strategy, it’s important for you to be disciplined about your payments when the money is flowing in. Will you apply the extra money to your mortgage payment or put the money aside for savings for the future? If not, you may be in trouble later when your mortgage payments shoot higher.
Before you shop around for a mortgage, it’s important to know where you stand credit-wise. You can pull your free annual credit reports to look for errors and to see if there are any issues you need to work on in order to improve your credit. You can also see where your finances stand by viewing a free snapshot of your credit report on Credit.com. You’ll receive pointers for improving your credit and helpful tips for which areas to focus on specifically. Checking your credit report snapshot will not harm your scores or report in any way.
This article has been updated. It was originally published September 12, 2014.