Thinking of buying a home this year? With interest rates, rents and housing prices all on the rise, this could be an opportune time to make it happen – and an interest-only mortgage loan might be the thing that makes it possible.
How Does it Work?
While not for everyone, an interest-only mortgage offers a host of advantages for some borrowers. As the name suggests, these loans allow you to pay only the accrued interest on the loan each month for a period ranging from 5 to 10 years.
Because you make lower monthly payments during this timeframe, you enjoy increased financial flexibility (meaning you can invest the difference or choose to pay principal in conjunction with a bonus or other cash influx).
After the interest-only period expires, the loan converts to a more standard structure where both principal and interest are paid on a monthly basis. At this point, you’ll see your mortgage payment go up – sometimes substantially.
Because of this, interest-only loans are typically better for borrowers who expect to be able to cover those higher payments in the future – for example, if you believe your income will increase before the interest-only period is up.
A Checkered Past
Interest-only mortgages have been around for decades, but for the most part they weren’t attractive to the masses. Typical borrowers were often affluent homeowners who viewed their homes as part of an investment portfolio: interest-only mortgages provided the opportunity to seek better returns with the capital that would otherwise have been used to make a higher mortgage payment.
Then came the housing bubble of 2004 – 2006, when lenders started approving interest-only loans for unqualified borrowers who wanted to keep mortgage payments low while trying to flip houses as quickly as possible.
After the bubble burst in 2008, the market for interest-only loans went dormant for several years – and these products were left with a less-than-favorable reputation.
The Opportunity Today
Between the current economic environment and the advent of new interest-only loan products, this type of loan is once again worth considering for some borrowers.
Again, the main stipulation is that you’re not biting off more than you can chew – meaning you expect to be able to handle the increase in payments once the interest-only period is up.
If you meet those criteria, here are a few advantages to consider:
1. Lower Upfront Monthly Payments
Because you only pay the interest that is accruing on the mortgage, initial monthly payments are substantially lower than if you were also paying the principal.
For example, on a $1 million, 30-year, 4% fixed mortgage, the initial monthly payment would be $4,774 – with about $1,440 of that going to principal. On an interest-only mortgage with the same criteria, the monthly payment would be $3,333.
2. Tax-Deductible Payments
Generally speaking, you can deduct 100 percent of your interest-only mortgage payments,as long as the total deduction is on debt less than $1 million.
On the other hand, mortgage payments that include payments on both principal and interest are only deductible for the amount of interest paid. In the example above, for each month’s payment of $4,774, only the interest portion ($3,333) would be deductible.
3. Rent vs. Own
As rents continue to skyrocket in metropolitan areas, many people would rather put that monthly check toward a home of their own. For example, the median monthly rent for a one-bedroom apartment in San Francisco is about $3,500.
With interest-only mortgage rates currently hovering around 4 percent, payments on a $1 million mortgage would be less than the cost of renting. Factor in the tax deduction benefit, and buying a home becomes even more attractive.
4. Seek Higher Returns
There are situations where paying down the balance of a mortgage may not be the most efficient use of capital, specifically when funds can be allocated to higher-yielding investments.
Much like the savvy borrowers in the early days of interest-only loans, you can take advantage of the flexibility afforded by lower mortgage payments to seek investments with higher returns. This advantage makes an interest-only mortgage a compelling choice for long-term wealth building.
Forecasts for 2016 and beyond include rising interest rates, increasing housing prices and the continuing escalation of the cost to rent.
These factors make 2016 look like an opportune time to buy a home. If the structure of a traditional mortgage has prevented you from buying a home, an interest-only mortgage may provide a solution that helps make that happen in the near future.
Download the SoFi Guide to First Time Home Buying to get valuable tips on these topics and more. Our guide also demystifies modern mortgage myths around down payments, the pre-approval process, student loans, rising interest rates, and more.
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