Loan Types #Mortgage Basics

What is an Interest-only Mortgage?


There are a variety of options available when it comes to making payments on mortgages. The most common is the traditional method of paying a portion of the principal plus interest on a monthly basis. A less common one is the interest only mortgage. 

 

So, what is an interest only mortgage? Simply put, an interest only mortgage Canada is one where you only have to pay the interest accruing every month for an initial number of years on the loan. 

 

An interest-only loan is a guarantee of lower payments for the initial years when you are paying only interest on your mortgage, however, once it lapses, you begin to pay both interest and principal back on a monthly basis. The terms of the loan may allow for principal payment during the ‘interest-only’ period, but it isn’t required. 


Key Takeaways
  • An interest-only mortgage allows you to pay only the interest on the mortgage for a period before you resume paying interest+part of principal
  • Traditional lenders seldom offer interest-only mortgages, they are more commonly offered by alternative lenders
  • Interest-only mortgages may come with flexible terms that allow you to pay back principal during the ‘interest-only’ period

Interest-Only Mortgage Risks

The primary risk associated with interest-only mortgages is the fact that each payment does not bring you a step closer to owning your home. Traditional mortgage payments usually comprise paying back a part of the principal, alongside the interest. Principal payment is how you build equity

 

Since an interest only mortgage Canada has you paying only interest on your mortgage, you are unable to build up equity, and your property would still be fully owned with borrowed money. In the event that you want to sell your home and pay off your mortgage, owning significant equity in it is vital. 

 

Little or no equity implies that you would be gambling on the possibility of your home’s value having increased enough to settle the loan leftover. More equity in your home implies that you would need to part with less to completely pay off your mortgage. This is ultimately easier than dealing with a huge chunk of the loan still unpaid. 

 

This extra risk has seen mainly alternative lenders being the only willing interest-only mortgage providers. Only lenders such as trust companies or private mortgage providers offer this service. 

How to Pay Off an Interest-Only Mortgage

There are a few options that the borrower can explore to make payment at the end of the interest-only mortgage term. Generally, borrowers opt for one of the following: 

  • Selling the mortgaged home to pay off the loan. This can be a practical choice especially if the home has appreciated significantly in value
  • One-time lump-sum payment from savings and investments over the years when they paid only interest
  • Refinancing the loan at the end of the interest-only mortgage term. This is one way to get fresh terms and potentially reduced interest rates which would be paid periodically alongside a portion of the principal  

 

So, can you pay interest only on a mortgage? Yes, you can, and these are the explorable options when paying back. 

Advantages of an Interest-Only Mortgage

While interest-only mortgages may seem quite risky, there are actually some upsides that this loan option offers. So, is interest only mortgage a good idea? It can be sometimes. 

 

It usually boils down to the borrower and their specific situation. Here are some advantages of interest-only mortgages:

Provides Leverage 

Given that the borrower doesn’t have to make payments on principal, the money saved from these payments can be put towards other uses. 

For instance, a mid or short-term investment with good returns can be a good call. While this is somewhat risky in itself, it just might pay off. 

Flexible Qualification Standards 

Since alternative lenders are the major providers of interest-only mortgages, they typically determine the terms that they would be using. 

These terms are less rigid in terms of how much they can lend and who they lend to. However, you would still need to meet some basic criteria like good credit history and a particular income level. 

 

Flexibility In Payment Schedule 

The terms of an interest-only mortgage allow for principal payments during the interest-only years. It’s just not mandated. 

This implies that if you get a windfall gain, you can pay off some principal and reduce future principal payments. To confirm that this is/would be allowed, ensure you check the terms of the agreement to confirm and look out for any restrictions or early payment penalties

Disadvantages of an Interest-Only Mortgage

Away from the benefits, certain downsides accompany taking out an interest-only mortgage as well. Here are the major ones:

No Guaranteed Exit 

There’s a chance that you would be unable to sell or refinance when you want to exit your interest-only mortgage. This is due to unpredictable factors like a fall in home value, a sharp rise in interest rates or income level being insufficient for a refinance.

 

Substantial Future Payments 

At the end of the interest-only period, you would experience an increase in monthly payments as a result of the commencement of principal repayment. 

If your loan is an adjustable-rate type, there’s a possibility that your interest rate may increase too. 

Since your interest rate would be determined by the prevailing market rate, you may see your monthly payment further increase. 

 

Costs More In the Long Term 

In the absence of a property sale or refinance, an interest-only mortgage would cost more than a traditional 30-year, fixed-rate mortgage or ARM. This is because of the principal payments that are relegated to the later years of the loan term. 

 

Tougher To Come By 

Most lenders do not offer interest-only mortgages since they are mainly a specialty product. This also implies that you may not be able to compare interest-only mortgages from multiple lenders. 

Lenders who offer them more commonly give interest only rental mortgages where the borrower starts out by paying interest only on investment property. 

Interest-Only Mortgage Alternatives

Are interest only mortgages available? Yes, they are. However, if you’re looking to explore other options that guarantee lower monthly payments, here are some practical ones:

A Longer Mortgage Term 

Spreading payment over more years or increasing the amortization period is a good way to reduce monthly payments. For down payments less than 20%, the maximum limit would be 25 years. However, if you pay in excess of 20%, you can get up to 30 years as the amortization period

 

Making a Larger Down Payment 

Making a larger down payment offers a ripple effect in benefits. It implies a smaller mortgage and reduced monthly payments. Less expenditure on interest and you can possibly pay back the entire loan faster. 

 

Opt for a Cheaper Home 

A cheaper home implies lower mortgage payments and a faster payment rate as well. You can comfortably pay off the mortgage and if your financial situation improves after a while, you can opt to move to a bigger home. 

Final Thoughts

An interest-only mortgage offers some great upsides and downsides too. The key to making a practical decision here is to weigh these factors in the light of your present and potentially, future situation. This can help you make the right decision. 

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