What are the advantages and disadvantages of an interest-only mortgage other than lower payments?

Answer 1

Interest only mortgages are geared toward a particular borrower since you pay only the interest on the mortgage in twelve equal payments for a period of years and after the end of that term you must refinance, pay the balance or start making payments toward the principal and the payments take a big jump.

Financial advisers do not advise the average wage earner to seek such a deal. They are geared toward borrowers such as an executive who only earns a salary in periodic bonuses or someone who expects to receive a big sum of money or earn a lot more in a few years because the interest only payments would result in the lowest monthly payments possible . . . for now.

A prudent interest only mortgagor needs to save & invest the money they are saving for those first few years. However, that takes skills the average homeowner usually doesn't have.

In a shaky housing market the value of the property could decrease while the amount you owe stays the same. If you can't afford the pending increase in payments you might find yourself upside down on that mortgage, owing more than your home is worth.

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See following opinions from contributors:

Pros

Free up cash flow - not necessarily in order to put into other investments but to make lives easier for the duration of the interest only payments.

Free up money to put into other investments. They are geared toward that market.

Payments are 100% deductible if one itemizes (those that take the standard deduction or have too few deductions to make itemizing valuable do not get the same benefit of a mortgage).

While there is truth that what might have been paid could be invested, most IO users have been shown NOT to do so and, in fact, end up in a worse situation because they expand the lifestyle to accommodate the excess cash flow and get into the P&I period where the payment increases notably.

When reviewing the foreclosure rates over the last few years, foreclosures rates on IO loans are not statistically higher than those on other products.

The benefits of an interest only loan are different based on specific economic circumstances and a generic set of assumptions does not hold, other than there is truth in the fact that many who took IO loans got more house than they otherwise may have gotten using traditional products.

Cons

There is no equity built during the interest-only period of an interest-only mortgage.

While there is truth that what might have been paid could be invested, most IO users have been shown NOT to do so and, in fact, end up in a worse situation because they expand the lifestyle to accommodate the excess cash flow and get into the P&I period where the payment increases notably.

In this economy, those utilizing an IO mortgage will eventually be subject to the vagaries of the interest rate market when the P&I payments must be made. In this case, many IO loans are VARIABLE and, given the low interest rate environment in which we are currently in, they are most likely going to have a higher interest rate moving forward.

Unfortunately, the "advantages" of interest-only and adjustable rate mortgages have put many people into a financial situation above and beyond their means. The enticement of a lower payment has tricked people into thinking they can afford double the home they should actually be buying. The increasing foreclosure rate is the best example of where it can lead.

The lower payments did allow people to get more house than they would have qualified for under a normal mortgage. This made sense if 2 or 3 assumptions held true.

1) The market was rising and equity was actually being built through appreciation.

2) The buyer would have the financial discipline to actually make principal payments.

3) The buyers income would increase to allow for greater principal payments and for the refinancing of the balloon payment that was often involved at the end of 5 or 7 years.

All in all, I would file these types of mortgages in the "Bad Idea" file as a consumer.