Tempting as it may be, choosing an interest only mortgage loan is not necessarily the best choice to make. There are considerable risks that should be taken into account first.
On the surface, it can seem that opting for interest only mortgage loans is a prudent financial choice. It is understandable, since it means only interest is paid for a period of time at the start of the repayment schedule, thereby alleviating the pressure that the borrower faces.
The idea of paying interest only is that it gives the borrower time to get on their feet, but the fact remains that the principal of the mortgage loan must still be repaid. So, in fact, the break is very much a temporary one.
The problem is that many people who apply for these interest only mortgage loans fail to factor this in. While they rejoice in the lower repayment amounts, it is a common fate that repayments are missed when the initial period comes to an end. In fact, foreclosures on loans agreed on interest only terms are statistically quite high.
But this is only one of several reasons why the risks are so much more acute, with high interest payments, delayed equity and the effects of interest rates also playing a part.
Increased Interest Amount
The chief problem with interest only mortgage loans is that the principal amount is not reduced. As a consequence, the interest rate, when applied to the full amount, will mean a higher monthly interest repayment.
For example, if an interest repayment is 5 per cent of USD100,000 in June, but 5 per cent of USD70,000 in December, then the payment falls from USD5,000 to USD3,500. But if the principal does not fall, the interest stays at the maximum.
When it comes to the end of the interest only term, and the principal must begin to be paid, the pressure is acute. This is partly the reason why the number of defaults on this kind of mortgage loan is so high.
Equity is Severely Effected
The true value of property is its equity, but since, with an interest only mortgage loan, the principal is not repaid then the equity does not actually exist. This is because under the terms of a mortgage loan, the lender owns the property in full but as the principal loan falls, the borrower is gradually buying ownership. Each payment is effectively buying a share of the equity.
Equity is important because it is against this that any future refinancing deals can be secured. So, by paying the interest only, the financial future of the borrower is actually weakened.
Effect of Interest Rate
There are two types of interest rates available as part of a mortgage loan agreement, namely variable and non variable. The difference between them is that non variable rates are set to an agreed monthly amount, whereas variable rates are affected by the market place.
With interest only mortgage loans, the upshot of having a variable rate is that the rate can fall, thereby saving money. But, should the rate rise, then the repayment will increase, sometimes dramatically.
A regular loan is not so affected by the interest rate, because the main share of the monthly repayment is the principal loan sum. For this reason, when it comes to an interest only mortgage loan, it is best to agree and non variable, or fixed interest rate. That way, when it comes to the end of the interest only term, the increase can be safely planned for, with no risk of any unexpected increases.