"Interest-only" is an option that can be added to almost any loan product. Both adjustable and fixed rate mortgage loans can feature an interest-only payment option.
For fixed rate mortgages, the interest-only period usually ranges from one to ten years-- meaning you can choose to pay only your monthly interest due and are not required to pay down any principal balance. If you choose to only pay interest your loan balance will not be reduced during this time. When the interest-only period expires you will then make a payment calculated to retire the mortgage over the remaining term of the loan. For example, if you had an interest-only period for the first 5 years of a 30 year loan, your new payment will need to be high enough to pay off the balance in 25 years. This is called a fully-amortizing payment and may be significantly higher than your interest-only payment. In general, the longer the interest-only period, the higher your payment will adjust when the interest-only period expires.
Adjustable rate mortgages generally feature an interest-only period of one to ten years also. Once the interest-only period expires, you will be responsible for fully-amortized monthly payments. However, adjustable rate mortgages differ from fixed rate mortgages in that there is an introductory fixed-rate period that may or may not coincide with your interest-only period. Once your introductory fixed-rate period expires you may see interest rate fluctuations and payment fluctuations as you pay off your principal balance.
Pros of interest-only loans:
Cons of interest-only loans:
- Lower payments in the beginning -- pay more as income increases
- Payment flexibility-- pay more when you can afford to and less when you can't
- Available on both fixed rate and adjustable rate mortgages
- Possible payment shock once interest-only period expires
- Possibility of negative equity if home values drop
- Little or no principal mortgage balance reduction
Interest-only options should not be taken lightly. They can be good for people with sporadic income but are not meant to be used to buy a bigger house than you can otherwise afford. Some like to use the extra monthly cash for investments or to pay off more expensive debt. However, no one should take an interest-only option without a clear plan for repaying the loan.