What is an interest only mortgage?

In an interest only mortgage, the borrower covers interest on payments for a specific period of time, paying the cost of borrowing money up front, while the principal remains unchanged. This allows for reduced monthly mortgage payments early in the loan term. An interest only home loan can offer flexibility to buy a more expensive home than a borrower initially qualifies to buy. They can also be a great way to lower payments so you can divert your cash flow toward retirement, college tuition or a rainy day fund.

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In traditional mortgages, payments are applied to both interest and principal. Through amortization the balance of the loan decreases over the term of the loan. Interest only mortgages are structured differently: The most common version pushes back the amortization schedule, usually 5 to 10 years, while the borrower pays interest only. The other type lasts the duration of the loan, with an agreement principal that will be settled with one balloon payment at the end of the term.

While initial payments as part of an interest only mortgage are lower, borrowers should be aware that over the life of the loan they are more expensive than traditional mortgages. Interest only loans can also be subject to adjustable interest rates. Negative amortization, a feature where missed interest payments are applied to the principal balance, is also a risk inherent to interest only loans. Keep reading to learn more and explore the circumstances that make the most sense to purse an interest only loan.

Is an interest only mortgage right for you?

Here are five questions to help you determine whether an interest only mortgage is the perfect match:

• Are you confident your income will grow in the future, but want to purchase high-value real estate now?
• Are you more interested in lower monthly mortgage payments than building home equity?
• Are you looking to invest your money in something other than your home?
• Are you fine with the prospect of your monthly mortgage payment going up when the interest-only term ends?
• Do you own investment homes and rent them out?

Blog source: rate.com