What Is An "Interest-Only Mortgage?"

"An interest only loan is a loan that allows the borrower to make interest-only loan payments for a set period of time," explains Doug Perry, who has worked in the Consumer Markets Division for Countrywide Home Loans for sixteen years. "It is a loan that that provides flexibility for a borrower because generally the interest-only payment is lower than a principal and interest payment. Those differences between an interest-only payment and a principal and interest payment tend to be the greatest as the loan amounts get bigger," he says.

The catch, for those obtaining an interest-only loan, is that when one begins to pay the principal, the payments may e very large. Someone with a tremendous amount of discipline might actually benefit despite the larger payments when the principal is repaid, because that person might be able to save money when paying only interest. He might invest the saved money and be able to pay off the mortgage more quickly,with money left over.

Those with seasonal jobs, like a construction worker, or someone in the tourism industry, might also benefit from an interest-only loan. When they are not working, it might be beneficial to have lower payments. When they are working, they might be able to pay higher amounts - to pay on the principal and not just the interest.

A single person, however, who has a good income, could possibly find better financing, with a lower interest rate, and pay off the house more quickly, with another type of loan. Experts also agree that an interest-only loan should never be obtained by someone who will use the extra money to pay for daily living expenses such as food, clothes, or monthly bills.

"An interest-only loan also requires that the borrower understand the objective, which is to pay off the loan. At some point (based on the loan terms), principal and interest payments are again required, and you are going to have to pay enough to catch up for those periods of time that you made interest-only payments," says Perry.

Another disadvantage for those with an interest-only loan is that while you are paying the interest only, you would not be building equity in your home. If you had a financial emergency, you might not be able to sell your home quickly.

As an example of how much your payments could go up when you would start to pay the principal after paying only the interest, if you had a loan at 4% and were buying a $500,000 house, you might pay a little more than $1,500 a month when paying only the interest. When you begin to pay the principal, and the rate rose to a capped 10%, your payments could jump to slightly less than $5,000.

An interest only loan can be a good thing for you, however, if you expect your income to dramatically rise in the future.

"An interest-only loan is a great option in terms of billing and financial flexibility, but it does require a little more borrower education and understanding," explains Perry. He adds that a potential borrower should make sure he fully understands all the loan terms.

In short, interest-only loans can be good for some people, but bad for others. It is best to consult with an expert before deciding if it is for you.