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How To Understand Interest Only Home Loans

When you pay your monthly home loan payment, you may have noticed that a part of it (however small) decreases the mortgage and the rest of it pays the interest. At least, that’s the way it used to work. But there exist now new types of mortgages that only pay the interest.

The home owner can decide how much to pay each month, as long as he pays an enough to will meet the interest, and does not change the loan balance. In most home loans, you have the option to pay more than the fixed loan payment, but the difference is that the interest only mortgage keeps the monthly payment as low as possible.

There may have been some rationale to this type of loan when property prices were increasing drastically, since the homeowner would be guaranteed some equity because of the increased home price. Normally, equity in a home is gained by a combination of paying off the principal and increasing home values.

Now that real estate values are falling rather than rising, the validity of interest only loans has been called into question. The only reason that one would prefer to have an interest only loan is to keep the monthly mortgage as little as possible. Today, it would really only work if it were used as a stop gap measure.

Perhaps there is a situation where one partner is not working or only working part time while he finishes school. Since, in theory, the student would eventually complete his studies and get a good job, keeping the home loan payment low during this period and ramping them up afterwards makes sense.

Another example would be where the borrower has income that varies greatly from month to month. Perhaps someone who worked on big projects and was only paid at the end of them might have such a pattern. Keeping the mortgage low in the months when income was low and then paying additional equity when the windfall came would be a sensible decision, as long as the discipline was there to make the additional payments.

In the current real estate environment, not building equity by paying down the loan could be a dangerous solution. If you are paying off the loan balance a little at a time each month, when it comes time to sell the home, you will have some equity in it, even if home prices have not gone up. However, if you always pick the interest only option, the loan principal will never be lowered, and the amount received by the sale of the home will not be enough to pay down the loan.

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