Do you need to keep the mortgage payments on your home as low as possible? A mortgage that requires you to pay only interest for the first few years might be your best bet.
How interest-only mortgages work
When you take out a traditional mortgage, you pay the lender a monthly amount that's a blend of principal plus interest. The principal goes to repayment of the money you borrowed. The interest is what the financial institution charges for the use of the money.
When you take out an interest-only mortgage, you pay only interest every month for a fixed period of time -- usually the first five to 10 years. Then, depending on the term of your mortgage loan, you have 20 to 25 years to repay all of the principal, plus interest. You can pay money toward the principal during the interest-only period, but make sure your interest is recalculated on the new balance.
An interest-only loan could be ideal for you if you are short of cash but want to buy a home in anticipation of an improvement in your financial situation. Refinancing with an interest-only mortgage is an idea you might want to consider if you are experiencing a temporary financial squeeze -- if, for instance, you or your spouse has chosen to go back to school, or one of you has decided to take a few years off with your children. Paying only interest for a few years could help you to stay in your current home, even though you can't make your conventional mortgage payments for the time being.
You might also choose an interest-only mortgage as a way of investing in real estate, if you believe house prices in your area will rise in the next five to 10 years. You could live in the house for that period, paying only interest, and plan to sell it, pay off the mortgage and keep the difference when the interest-only period expires.
Slash your cash needs
You can free up a lot of money each month with an interest-only mortgage.
Let's say you have a mortgage of $200,000 and that the interest rate is 4.75 percent. With an interest-only mortgage and no principal payments due for five years, your mortgage payments for the first five years will be $791 a month. With a regular five-year adjustable-rate mortgage and the same interest rate, you would pay about $250 more per month, or $15,000 more in five years.
Since interest payments on your mortgage are generally tax deductible, you may be able to deduct 100 percent of your monthly payment with an interest-only mortgage. Consult your tax advisor to confirm whether you are eligible to do so.
Your payments rise later
When you take out an interest-only mortgage, whether it's for the purchase of a new home or to refinance your current home, you must bear in mind that when the five- or 10-year interest-only period expires, your payments will increase. In fact, they will be much higher than if you had taken out a conventional mortgage. This is because you must now pay off the principal in a much shorter period of time.
