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How to Understand Interest Only Mortgages
When you pay your monthly home loan payment, you may have noticed that a part of it (however small) reduces the mortgage and the rest of it pays the interest. This was how most mortgages were until recently. A new type of mortgage has been designed to permit the monthly mortgage payment to be as low as possible, by requiring only the payment of interest.
The home owner can choose how much to pay each month, as long as he pays an amount that will meet the interest, and does not change the loan balance. Even with more conventional mortgages, you could pay additional on your mortgage to pay down the principal balance faster, but the idea here is to keep the monthly payment low.
There may have been some reason for this type of loan when property prices were increasing dramatically, since the borrower would be guaranteed some equity because of the increased home price. Equity was built by a combination of mortgage paydown and increased housing values.
Today's falling housing market means that homeowners can no longer count on an automatic increase in their home value. The only reason that one would prefer to have an interest only loan is to keep the monthly payment as low as possible. Today, it would actually only work if it were used as a stop gap device.
One example may be when a two income couple temporarily only has one income, for instance if one of them was going to school. Theoretically, once the other partner completes school and starts a job, the home loan payments can be increased to begin to lower the loan.
Another example may be where the borrower has income that varies greatly from month to month. Maybe a project consultant is only paid at the end of a project. Keeping payments low in the months when income was low and then paying additional equity when the windfall came would make sense, as long as the discipline was there to make the additional payments.
In any of these instances, it is dangerous to not increase the payment at some point in so as to bring the loan balance down. As mentioned, with "old fashioned" mortgages, the mortgage was paid down gradually because part of the monthly payment went towards principal, so the owner had some equity even when the value of the home did not go up. If no equity has been paid off, the owner will have to raise additional money to pay off the mortgage when home values have not sufficiently increased.
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