7% Mortgage Rates Make Interest-Only Loans More Tempting: Here's What To Know
Buying a house is the most expensive purchase many Americans make. As interest rates rise, monthly payments become harder to afford. As of Oct. 29, interest rates for a 30-year fixed-rate mortgage are currently 7.24%, per Freddie Mac.
With rates climbing, an interest-only mortgage becomes more attractive. Such mortgages can offer breathing room, but the risks may not be worth the benefit for most.
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What an Interest-Only Mortgage Saves You
The key benefit of an interest-only mortgage is that it can help with affordability. According to Freddie Mac, you repay only interest for the first several years of the loan, usually five to seven years. This appeals to people who want to buy a house but can’t afford a traditional mortgage.
The immediate result is a lower monthly payment that doesn’t restrict cash flow as much. You’re not getting a cheaper house or reducing indebtedness; instead, you’re delaying principal repayment.
Once the interest-only portion ends, you begin repaying principal or you can refinance, apply for another interest-only mortgage or move, per Chase.
The Biggest Risk Is a Looming Problem
As rates spike, it's understandable to consider an interest-only mortgage. Aside from the lower initial monthly payments, this financing option carries several key risks.
When the interest-only period ends, you begin repaying principal. This can significantly increase your monthly payment. If circumstances haven't improved, you may be forced to make a difficult decision. Refinancing will generally be possible, but there’s no guarantee rates will be lower or that you’ll qualify for the loan.
Worse yet, what happens if the house price declines during the interest-only period? Because you make no principal payments, you could end up with negative equity, according to The Wall Street Journal. If you need to delay a traditional mortgage to buy a house, waiting until you can may be more beneficial.
When Is an Interest-Only Mortgage Feasible?
Getting an interest-only mortgage isn't always bad, per se. They can make sense for some buyers under the right circumstances. Even though they offer lower initial payments, some buyers may want an interest-only loan for other reasons.
According to Chase, buyers purchasing a second home and real estate investors may find the mortgage tool suitable, since they may not stay in the house long. The bank also argued that people who can pay off the loan quicker than a traditional mortgage may find the interest-only opportunity enticing.
With proper planning, high-income earners or those with substantial assets might be able to take on the responsibility.
Ask Yourself This Before Considering an Interest-Only Mortgage
An interest-only loan can make a house payment more affordable. That can be appealing in a rising interest-rate climate. For instance, a 1% increase can make a typical mortgage $60 to $70 more expensive each month for every $100,000 borrowed, per Rocket Mortgage.
Looking at how much lower your payment will be with an interest-only mortgage isn’t prudent, though. A better approach is to determine whether you can reasonably afford the house when the interest-only period ends.
Get quotes for both a standard and an interest-only mortgage. Compare the two instead of focusing only on the introductory payment. If you can't manage the standard mortgage and don't want the risk of interest-only, other options exist. Purchasing a cheaper house, opting for another mortgage option or waiting are all possible solutions.
Interest-only mortgages may seem more compelling as rates stay above 7%. They temporarily reduce monthly payments, but they can balloon in a few years. Unless you have a specific plan and strong resources, the risk may not be worth it.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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