As rising mortgage rates drive up the costs of buying a home, consumer demand has soared for a recently-introduced type of mortgage that offers the security of a fixed interest rate but with relatively low monthly payments in the loan’s early years (fixed-rate interest-only mortgages). These loans, which barely existed two years ago, now account for 8% of all new residential mortgages.
Rates on 30-year fixed rate mortgages currently average 6.62%. Rates on one-year adjustable rate mortgages now average 5.81% – the highest since 9/2001. People who calculated what they could afford when rates were 5.25 percent and less have realized their mortgage payments are going to be a lot higher now that rates have gone up, so they’re going for interest-only loans.
Some analysts say the savings from taking out a fixed-rate interest-only mortgage diminish as mortgage rates rise, especially when 30-year fixed-rate mortgages rise above 7%. Once you do begin paying principal, you have to make larger payments to pay down your debt before your term is up.
These loans can be of value for people who want to save or invest the money they would have paid in principal, but many borrowers have been encouraged to stretch their budget and buy more real estate than they can comfortably pay for in the long run.
The most popular interest-only mortgage requires that you pay only interest, no principal, for the first five years. The initial savings is impressive. If you borrow $200,000 using an interest-only loan and no principal payments due for five years, your monthly payment could be about $440/month less than if you took a 30-year fixed loan. That adds up to $26,000 in lower monthly payments for the first five years of the loan.
This might work for you if you have other money you are investing elsewhere and can be assured of covering the suddenly higher interest rates you will face in five years. However, there is no guarantee that your house price will appreciate and if you stay in it longer than you had planned, that suddenly higher interest rate (much higher interest rate) could prove stressful, to say the least.
Besides people who are investing their cash elsewhere, interest-only loans also make sense for people whose income is sporadic – either because you are paid on commission or because you receive annual bonuses. In this case, you have the option of only paying interest some months but you can pay above and beyond the amount due when you get your bonus checks. There is typically no prepayment penalty on interest-only loans. The benefit of this advantage, however, is only as good as your fiscal self-discipline.
If you are thinking of taking one of these loans because it is the only way you can imagine being able to afford a house, you are exposing yourself to a high risk. If you are neither managing to save money while in the interest-free period, nor are you building equity in your house, you may find yourself in a scenario where you owe more money than your house is worth and you face interest payments that you cannot cover.