When it comes to buying a house, many people are convinced to use an interest only home loan as a way to finance the purchase. Interest only home loans are tempting because they hold the promise of getting “more house.” Lower monthly payments make it easier to afford a home that is otherwise out of one’s range. But there are several problems with interest only home loans. And, though they are ideal for some people, for most of us an interest only loan is a financial mistake.
How an interest only home loan works
Interest only home loans work as follows: A home mortgage is financed in such a way that the purchaser only pays the interest on the home loan for the first 5-7 years. This keeps the monthly payment initially low. The home buyer can be approved for a much larger amount because this method of creative financing allows the monthly payments to be well within budget. But, after the initial period is over (usually 5 to 7 years, but sometimes as many as 10), it becomes time to start paying on the principal. The monthly mortgage payments balloon into something much more than one had been previously paying. You can see where the problems might start to kick in at this point.
Disadvantages to interest only home loans
There are several disadvantages to the interest only home loan. The biggest and most obvious disadvantage is that ballooning payment. Few people really think about how big their payments will be once the initial period is over. Or they are certain they will be making more than enough money at the time. Often, just how big that payment becomes is a shock. A very unpleasant shock. And if the interest only home loan was obtained in order to get a “little more house,” and if one’s income has not caught up with the payments, the house could be lost. Here are some other disadvantages to an interest only home loan:
Not building equity. When you are only paying on the interest for your home mortgage, you are not building very much equity in your home. The only equity you end up with is the appreciation of the house. In many markets, that is not a very big number. 5 to 7 years is usually enough in most cases to start building equity, but when you have an interest only home mortgage, you will not build hardly any.
Moving into a home beyond your means. Sure, everyone wants a comfortable home. But an interest only home loan can put you into a house, and into a neighborhood, that is beyond your means. The property taxes on such a home may be more than you can afford, for example. With an artificially low monthly payment, you might forget about other home ownership costs that may be out of your reach in a larger home.
Emotional stress. Money stress is one of the biggest causes of tension in marriage. Many people do not factor in the kind of stress being short on money causes in a relationship. When that balloon payment arrives, or when you find out how much you owe in taxes, sleepless nights and arguments can follow, taking a toll on your emotional wellbeing.
Who an interest only home loan might be good for
Interest only home loans aren’t all bad. There are some people that can handle them, and that they work out very well for. The key is to carefully consider whether or not you fit into this rather limited category. First of all, you should know your risk tolerance. A high risk tolerance is necessary for someone who gets an interest only home loan. Additionally, interest only home loans tend to be useful for entrepreneurs and salespeople. This allows them to get a home with a low monthly payment (just make sure it’s not “too much house”) for the lean times, and allows the flexibility to put substantial chunks toward the principal during the better times. And it is essential to pay toward the principal during the initial period when you have an interest only home loan. That way your balloon payment will not be as large when the time comes.