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Interest Only Mortgage
Interest Only Mortgage
An Interest Only Mortgage is a type of Adjustable Rate Mortgage that has a period of "Interest Only" payments. One of the most interesting features of this mortgage type is the payment reduction. It allows borrowers to be able to afford more house because of the fact that they are only paying interest. On the other hand, if the borrower only pays the interest every payment period then the mortgage doesn't amortize (the principal amount stays the same even after payments are made). For certain situations an Interest Only Mortgage can be an effective tool. These situations include:
Fluctuating Incomes
Families that face a fluctuating income like jobs that incorporate large bonuses or commissions can benefit from an Interest Only Mortgage by having the flexibility of making a small payment when finances are tight and paying a bulk principal payment when cash is more abundant.
Trading Up
Some families buy a smaller, less valuable home as a "starter home" then trade upwards after a couple years. This action creates a lot of transaction costs and moving costs associated with purchasing a new home. Instead the same family would benefit more by purchasing the larger home from the start, making interest only payments for the same period and making bulk principal payments when they can afford it.
Investing
A savvy investor would benefit from taking out an Interest Only Mortgage on their home if the additional cash flow went towards investments that exceeded the interest amount of the mortgage. The theory behind this is to avoid "dead equity" by making large principal payments. With a Traditional Fixed Rate Mortgage principal payments keep equity in a home that may not be appreciating as quickly as other investments could be.
Quick Capital Gain
In an appreciable housing market some may benefit from an Interest Only Mortgage by buying a house that they might not be able to afford with the full Fixed Rate Mortgage payment. The idea behind this is to purchase a valuable home in a market experiencing growth, make interest only payments, then cash in on the equity associated with the growth in value. In this case equity is established with the rising value as opposed to principal payments.
Allocate Cash Flow to Other Debt
Debt that has a higher interest rate or unfavorable terms could be paid off quicker by using an Interest Only Mortgage. The reduced payment associate with an Interest Only Mortgage allows resources to be focused on "bad debt." Once the bad debt is paid off those resources can either be used to pay down principal on the mortgage or used for other investments.
Reduce Future Payments
One of the most interesting features with an Interest Only Mortgage is the ability to reduce mortgage payments by paying on the principal. If a payment (or multiple payments) is made on the outstanding principal the interest is calculated using the new principal thereby reducing the Interest Only payment. This is different than Traditional Fixed Rate Mortgages and Adjustable Rate Mortgages. With a Traditional Fixed Rate Mortgage the payment remains the same no matter how much extra is paid toward principal. The only thing that changes is the amount of payments that need to be made. With an Adjustable Rate Mortgage the payment changes but not until the next adjustment period.