How To Understand Interest Only Home Loans
Most mortgage payments are split into two when they reach the bank; a small part reduces the equity, and the balance pays the interest. At least, that’s the way it used to work. Some lenders have now introduced a new type of loan to attract more borrowers by keeping the monthly payment as low as possible by only paying the interest.
This means that if you choose an interest only option, every month you pay your mortgage, the loan balance stays exactly the same; it never goes down. Even with more conventional home loans, you could pay additional on your mortgage to reduce the principal balance faster, but the idea of this loan is to keep the monthly payment down.
This loan had its place when home prices were escalating, since even if you never paid down part of your mortgage, you would still have plenty of equity because of the home’s increased price. Normally, equity in a home is gained by a combination of paying off the loan value and increasing home values.
Now that real estate values are falling rather than rising, the validity of interest only loans has been called into question. The only reason that one would prefer to have an interest only loan is to keep the monthly payment as little as possible. But it should definitely only be used as a temporary measure.
Suppose, for example, that a couple bought a home at the time when one of them was employed and one of them was still studying. Since, in theory, the student would eventually complete his studies and get a good job, keeping the home loan payment low during this period and ramping them up afterwards makes sense.
Or perhaps a home owner has a sporadic type of income, where he earns very little for a while and subsequently receives a large sum. Such an example may be a project worker who is only paid when the project is complete. Keeping the mortgage low in the months when income was low and then paying into equity when the windfall came would make sense, as long as the discipline was there to make the additional payments.
In the current housing environment, not building equity by paying down the loan could be a dangerous solution. Using a traditional loan mechanism, if the home value is lower, flat or only increases slightly, the margin of equity that the borrower deposited will cover the difference. However, if you always pick the interest only option, the mortgage principal will never be reduced, and the amount received by the sale of the house will not be enough to pay off the loan.
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