Why are interest only mortgages so bad?

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I’m looking into different loan options and ran across the “interest-only” mortgages. I’m not sure if I’m understanding it or not. Anyone that can do a better job than the financial websites help!

I understand that you pay only interest for the first 10 years. Then after that you start paying on the principal. Correct? If this is the case why is it so risky? With a regular loan I’m going to have to pay both the principal and the interest at the same time. So what’s the difference if it’s split up?

My husband and I are looking to make a fairly big jump in houses. This of course means we need to acquirer a larger mortgage. We both have excellent credit and great paying skills. Example, if our mortgage is $ 600, I’ll pay $ 700 a month.

9 Comments
  1. Reply
    anonimitie
    February 21, 2011 at 4:44 pm

    With interest only, you’re betting that the value of the house will go up and produce it’s own equity. If you’re wrong, a distinct possibility, and the value decreases, you’re underwater in your house and moving from it could be a financial hardship.

  2. Reply
    Woof
    February 21, 2011 at 4:53 pm

    You misunderstand. For those first ten years, you pay ONLY interest and build no equity (unless the value of the property appreciates). After that, you start paying a higher payment that consists of BOTH principal and interest – not “just the principal.” Over the life of the loan, you will pay MORE in total interest vs. a fixed-rate loan.

    With rates as low as they are now, it makes much more sense to lock in a fixed-rate loan.

  3. Reply
    glenn
    February 21, 2011 at 4:54 pm

    I am helping someone attempt to sell their home right now. They bought it five years ago on a interest only zero down loan- so they still owe what they bought it for.

    If they had paid some of the loan in principal payments their loan amount would be slightly lower and since our market is better than normal- we may have been able to sell it without them paying out of pocket- that is not true as it sits.

    They do not have as good of jobs as they once did and yet when the loan switches over to a principal/interest loan payment they will be paying a higher amount each month and that will be tough on them. The interest only loan enticed them to stretch beyond what they should have- this may also be true in your case.

    Be very careful. You don’t want your home to be a cause of stress- but a refuge from stress.

  4. Reply
    KL
    February 21, 2011 at 4:55 pm

    To add on to the other answers. After the 10 years the loan also re-amortizes to a 20 year term, so your payment not only goes up by the principle amount, but also because of the shorter term.

    If you can’t afford to pay both principle and interest on a mortgage then you shouldn’t take the mortgage. Interest-only loans are good for commissioned employees who’s income may be really high one month, then really low the next month but not regular W-2’d people.

  5. Reply
    the kid
    February 21, 2011 at 5:08 pm

    With interest only, you gain no equity unless value goes up on it’s own. So if you want to sell in 5 years, none of you payment has gone to building any equity at all. That sucks.

  6. Reply
    Flusterated
    February 21, 2011 at 5:48 pm

    Well now we know where that “one person” is who hasn’t been paying attention to the news for the past 4 years! If you can’t afford a mortgage on a fixed-rate 30 year ammortized loan, then you CAN NOT AFFORD THE HOME – period. You see all those foreclosures on your block and in your surrounding city? THAT is why interest-only mortgages are bad. Go back 3 years & start reading your newspapers….

  7. Reply
    Jack E
    February 21, 2011 at 5:59 pm

    They are not bad. They are good.

    If you get an interest-only mortgage, you get to live in the house free!
    You pay only the interest on the price of the house.
    When it converts to an amortized loan, inflation of currency will have occurred and the payments will be small.

    You will have won.

  8. Reply
    Debdeb
    February 21, 2011 at 6:00 pm

    An I/O isn’t bad, it just isn’t right for most people.

    There’s a time frame, anywhere from 3 to 10 years, when your payment is only interest. At the end of that time, the payment increases to include principal and re-amortizes. After 10 years, you will have no more equity than you did on the day you got the loan. It’s like renting your house for 10 years. Many I/O loans do not allow principal reduction payments.

    This loan is meant for someone who knows he’ll be earning a lot more money in a few years, or someone who won’t be there long enough to build equity anyway. One example is a doctor who is a resident in a hospital. He’ll be making a bucketful of money in 5 or 10 years, but right now, he wants to get the step-up home and get the kids in the right school district, etc. When his payment increases, he’ll still be able to afford it. Another example is a corporate person who gets transferred every couple years. He won’t be in his home long enough to build equity, but he doesn’t want to rent either. For most people, our incomes will not be significantly different in the next 5 to 10 years. And this loan is poison for anyone who is or is about to retire.

  9. Reply
    acermill
    February 21, 2011 at 6:01 pm

    Understand the concept of ‘interest only mortgages’. Assume that you pay $ 400K for a house and take out such a mortgage for $ 375K. After ten years, you STILL owe $ 375K. Are you anywhere near certain that the value of what you bought will be $ 375K or more after ten years ? If that property is then worth $ 325K at time of sale, you have paid a bunch of interest, AND you would owe $ 50K in cash at closing. The choice is yours (and doing so is NOT a smart choice)

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