Interest only mortgages are the mark of the real estate bubble. Then easy to access, and incredibly variable in the payment flexibility, interest only mortgage loans were intended as an easy route to homeownership. While getting an interest only mortgage loan may take more work now than it had previously, the right borrowers purchasing a home in the right areas can still access interest only credit options to reach their goals of home ownership.
Why Interest Only?
One of the best advantages to borrowing with an interest only stipulation is that the borrower need not pay large sums of money each month to maintain their home. Interest only means that each monthly payment goes toward interest, not principal, and that the balance of the home can be paid down as the borrower wants to pay down the mortgage.
Under an interest only plan, a homeowner would not own any equity in their home unless they made additional payments on each monthly payment. There are some disadvantages, however:
Interest only loans are variable rate – a variable rate loan is one in which the interest rate moves up and down with the market. This means that from each month you may pay more or less to the lender as the interest changes with each change in the interest rates the banks are charged.
No equity – Without an extra payment your loan balance will never shrink. Instead, you’ll send a payment to a mortgage lender each month just to keep your balance from growing.
Limitations – Borrowers who want to go the interest only route will have some limitations. These will include getting a loan that is no more than 20-30% of the borrowers annual income, as well as putting down a sizable down payment to ensure the bank’s safety in lending money to the borrower.
Those who cannot get an interest only loan might opt for a balloon payment loan. Balloon payments are fixed payment schedules that allow a borrower to pay only the interest for the first part of the loan. As predetermined by the borrower and the bank, a balloon payment will allow for the borrower to pay only the interest for 1-10 years, at which point a “balloon” payment will be due.
After the ballooning period, a borrower will pay either a larger monthly amount, or pay off the loan in full by refinancing it into a 15 or 30 year mortgage. This allows the borrower to purchase a home with the understanding that the real estate market will rise and the borrower will earn equity with appreciation or plan for a steadily increasing wage to pay for a larger home in the future.
Interest Only for Rentals
Interest only loans are also a very part of the investment market for real estate. In financing a home with an interest only loan, you can be sure that each home you have is cash flow positive. That is, with an interest only mortgage loan you might be able to buy a duplex or 4-plex that generates rent of $3000 per month. If you secure an interest only loan, then you’ll need to pay only the interest, which should be far less than $3000.
In this scenario, you have purchased a home and financed it inexpensively, allowing you to pay $3,000 in interest against several thousands of dollars in rent, which can then trickle into your pocket. This strategy is risky, as there is no equity in the home, however many people have used it to finance many millions of dollars in real estate which provides the landlord with 10-12% per year in returns while costing him or her only 5-6% in interest. On $1 million of property, that works out to $50,000-$70,000 in cash flow just for signing to buy a home and leasing it out. What could be better than that?
Besides, don’t forget the upside! If over the next 10 years this property were to increase in value to $1.5 million, a steady return of just over 3%, then you would also profit $500,000 in the appreciation of the homes. Once sold, the money can be used to pay back the loan in full.