Interest-only mortgages have drawbacks
Interest-only mortgages can be very enticing at first glance. For varying periods of time, depending on which mortgage plan you choose, your monthly payment consists only of the interest portion of your mortgage. You have extra money every month for other investments. You’re even able to buy a more expensive home, since the mortgage payment is smaller. And you can still make the occasional payment on the principal if you want. Sounds good, doesn’t it?
In some cases it is, but don’t jump too fast. If you’re not making principal payments, you have no equity unless housing values in your area appreciate. If values decline and you need to sell, you could be faced with an upside-down situation: You owe more than the house is worth. This is extremely risky if you live in an area of the country where home values have been rising rapidly, because at some point the rapid acceleration will stop.
Most interest-only mortgages are adjustable-rate mortgages. The rate on an ARM can rise dramatically at the end of the term when the principal needs to be repaid and that amount is added in. You can’t predict what the interest rate will be at the end of the period, and your mortgage payment can rise significantly. You also can’t predict with certainty that your income will have grown enough to easily cover the increased mortgage.
If an interest-only loan is used in a standard fixed-payment 30-year mortgage with a five-year interest-only term, at the end of the five years when the principal must be paid, the payments will be larger than if you’d made standard principal and interest payments. The reason: You now have only 25 years to pay off the principal, and you’ll continue to pay interest.
Bottom line: If you’re considering what seems to be a perfect interest-only loan, remember that at some point you have to pay the principal: the underlying debt. Your best bet, if you go with an interest-only loan, is to invest the additional money where it will increase faster than housing values. At the very least, put the money back into your principal as often as you can.