An interest-only mortgage is when a borrower only pays the interest portion of the mortgage, through monthly payments for a term that is fixed.
The interest-only mortgage loan term is usually between 5 and 7 years.
This type of loan can be useful for first-time home buyers who may not be able to afford large repayments towards a mortgage.
How an interest-only mortgage works:
The whole of the monthly mortgage payment is made up of interest, so none of it goes towards paying off the loan.
The borrower repays only the interest portion of the mortgage for a set number of years. Thereafter the borrower is required to pay the full outstanding principal amount.
Pros of an interest-only mortgage:
You can benefit from lower monthly payments during the loan term. Unlike with a conventional mortgage, your payments may be significantly lower, giving you the freedom to use any extra funds towards paying other expenses.
The borrower can buy a larger home later by qualifying for a larger loan amount.
During the interest-only period, the whole amount of the monthly payment qualifies as tax-deductible.
Cons of an interest-only mortgage:
Many people can’t afford principal payments when the time arrives. Once the term ends the borrower becomes liable for the full amount. This is a factor that often catches many borrowers unawares and leaves many fumbling once the time comes for them to pay.
Many people are not disciplined enough to pay extra toward the principal amount even when they have extra cash available.
The home may not appreciate as fast as the borrower would like.
The payment could increase significantly.
Some mortgages have penalties when a borrower prepays. So it’s essential to ensure that a borrower checks with a lender before applying for an interest-only mortgage.