Traditional Versus Interest Only Home Loans

by Lois Center-Shabazz

Published on this site: April 2nd, 2005 - See more articles from this month...

Once only a tiny percentage of the mortgage market; interest only mortgages consist of about 10% of the current market. And mortgage companies seem to advertise them quite a bit these days.

An interest only mortgage loan is when you pay interest only on your mortgage loan for a specified period, usually 5 or 10 years. During this period none of the principle is paid, unless you put a substantial amount on the down payment toward principle. If you have an interest only, no down payment loan you are paying absolutely nothing on the principle. At the end of the 5 or 10 year period your mortgage loan is amortized over the remaining period of 20 or 25 years, for a 30 year loan. So for example, if your interest only period was 10 year s, your principle loan will be amortized over 20 years.

If you have a 100% interest only loan, you are not building up equity in your home. In essence you are leasing a home for the tax deduction. The interest payments are tax deductible, but at the end of a 10 year period your payment could increase by 50% when the loan is re-amortized.

This type of loan would work in rare instances. One is with investors who plan on fixing up a home that they will sell quickly. It may also work for someone who will probably make a lot more money in 10 years than currently. Say for instance a physician who is a cardiovascular resident, but when he or she finishes will be able to cover the increased mortgage after 10 years because of a large spike in income as a cardiovascular surgeon. Also, someone who knows they will move in 2-5 years, as this is only a temporary stay.

Getting an interest only loan will allow homeowners to buy much more house than they could afford with a traditional loan. But does this make sense? With the more expensive home comes the more expensive costs. Such as the car that fits the neighborhood, and the private school everyone sends their kids to. Of course, most should know that with a bigger home comes bigger maintenance cost.

Since most housing experts feel we are at the top of the housing markets as far as home values are concerned, this is risky. Say the housing market decreases in value by about 20-30% like it did in Southern California in the early to mid 90's. You will be left with a minus value in your home and a monthly mortgage that will increase in 5-10 years. When home values are less than the loan against a home, the home becomes very difficult to sell, especially when you have to pay the difference from your pocket.

My picture of wealth building is finding a home you can afford to buy with current income, placing a down payment on the home, and paying on interest and principle. Building equity, paying as much of the principle as you can possibly afford, while placing money in a savings account, retirement account, paying bills on time, and keeping credit accounts to a bare minimum.

Lois Center-Shabazz is the author of the award-winning book,Let's Get Financial Savvy! ISBN #0971979502, and founder ofthe personal finance website, www.MsFinancialSavvy.com.