How to Understand Interest Only Mortgages
When you pay your monthly home loan payment, you may have seen that a part of it (however small) decreases the mortgage and the rest of it pays the interest. That’s the way a normal mortgage should work. A new type of loan has been designed to permit the monthly mortgage payment to be as low as possible, by requiring only the payment of interest.
Basically the borrower can pay what he wants, provided he covers the minimum of the interest payment. Just about all mortgages allow you to pay down a higher balance than the minimum, and interest only loans are not different; you can pay more if you prefer.
There may have been some reason for this type of loan when home prices were increasing drastically, since the borrower would be guaranteed some equity due to the increased home price. Normally, equity in a property is gained by a combination of paying off the loan value and rising home values.
However, changes in the real estate market mean that this type of increased value is no longer guaranteed, so any equity has to be built by paying down the principle. There are situations where interest only loans are a good idea. But these situations should only be temporary ones.
One example could be when a two income couple temporarily only has one income, for instance if one of them went back to school. Theoretically, once the other partner finishes school and starts working again, the mortgage payments can be increased to start to reduce the loan.
Another example would be where the homeowner has income that varies greatly from month to month. An example of this could be someone who did project work and was only paid at the completion of each project. It would be in his best interest to maintain his mortgage payments low during the periods of no income and raise them when the large income was received.
But for any of these cases, the homeowners cannot count on the value of the home rising and has to make sure principal payments are made. As mentioned, with old fashioned mortgages, the loan was paid down gradually because part of the monthly payment went towards principle, so the owner had some equity even if the value of the home did not go up. If you merely pay the interest each month, you will never lower the principle, and if the home sales price is lower than the home loan, you will not be able to pay down the loan.
