Mortgage Interest Only Loans Pros and Cons

2007-03-08 10:33:40

( Financial )



There are benefits and there are pitfalls to mortgage interest only types of financing deals. Consequently, proper deliberation should be undergone before taking out an interest only loan. Deciding to take interest only mortgage loans without full awareness of the advantages and the disadvantages can mean suboptimal benefits and even financial catastrophe.

Mortgage interest only loans give a debtor the opportunity to make interest-only payments on a mortgage loan for a few years; the industry standard is around 5 years. In this initial phase of interest only mortgage loans, the debtor can therefore expect lower monthly mortgage dues. This is basically the main benefit of mortgage interest only loan deals.

When you are paying only the interest on your mortgage, you will be able to save money. The difference between what you would have been paying if you had taken a fully amortizing loan and the actual monthly payment you have to make in an interest only loan can be substantial. This differential can be invested in high-yield monetary instruments like money markets or the stock markets. As such, the differential is earning you more money which can then be used to reduce your principal or offset your future amortizing payments.

You may also decide to use the differential to resolve your temporary cash flow problems, say to pay off current debts in time so as to prevent and increase in interest rates. You may also use the money to fund your retirement plan or your children’s educational fund.

However, mortgage interest only loans have one great drawback. The interest only loan payments will not last forever. After the initial non-amortizing period has passed, you are expected to make monthly payments comprised of the interest (the rate of which may have also increased from your initial interest rate) and a portion of the principal.

There is a great jump in monthly mortgage payments in this case. The sudden change from a monthly mortgage interest only payment scheme to a fully amortizing payment scheme can be greatly devastating to the unprepared debtor. When this unprepared debtor defaults on the loan, the interest rates will increase and the monthly payments get even bigger. Consequently, debtor is rendered even more unable to pay and the interest rates rise even more. It is a vicious self-reinforcing cycle leading to financial catastrophe.

In conclusion, if you want to take out a mortgage interest only loan, you had better do so because you are going to use your money to generate more income or you need it for other expenditures that you value. However, you also need to be aware of your future expected payments when the initial interest-only payment period has passes. Make sure that your expected income at that time more than makes up for the jump in mortgage payments. If you don’t, you have just signed your financial death warrant.


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