With an interest-only mortgage you pay mortgage interest, and no principal, for a specified period of time. Your mortgage balance remains the same; it does not increase, or decrease.
Interest-only mortgages can push an emotional button for those who are financially conservative. Before the advent of IRA’s and 401(k)s the home mortgage was often the only savings plan that people had, and could afford, and most Americans stayed in their home until their mortgage was paid off. Today, with a multitude of savings options and a very mobile society, the decision whether to pay principal on your mortgage should be made based on your long-term financial plan. Paying principal on your mortgage will give you an after-tax return on the principal payment slightly lower than the mortgage interest rate.
Advantages of an interest-only loan:
Disadvantages of an interest-only loan:
Paying interest-only is always optional: during the interest-only period you can pay principal if you choose. If you do pay principal, your loan will amortize as it would if it were not interest-only.
Let’s say your interest only payment is $2500 per month, and would be $3000 a month if you had a 30-year fixed loan and were paying principal and interest. If you pay $3000 a month on the interest-only loan your loan amortizes—the principal balance decreases—just as if it was a regular, fully amortizing, loan.
If you choose the interest-only option with a 30-year fixed or a 15-year fixed, you will have to begin paying both interest and principal after either ten or fifteen years, depending on the lender. This will mean a much higher payment.
A $500,000 loan with a 6.00% interest rate would have an optional interest-only payment of $2500 per month for the first ten years. If you paid no principal during those first ten years, beginning in year eleven your payment would increase to $3582 per month. Although this is a big jump—over $1100—it represents an increase of only 3.66% per year, compounded, over the initial $2500 a month payment, roughly in line with the current inflationary trend.
