Interest-Only Mortgages: Pitfalls you should avoid
When it comes to buying that dream home, many simply jump into that adrenaline rush without regard for their finances, which can lead to serious troubles later. With the excitement of owning a new home comes the lure of having interest-only mortgages that promise lower monthly payments for something you cannot really afford. First time home buyers and those who are easily tempted need to beware that the word “Interest-Only Mortgages” can easily mislead you in the first place. In the world of mortgages, there is just no such thing as paying for only the interest of your loan. Don’t ever fall into believing that interest-only mortgages will free you from paying off your principal loan amount.
Interest-only mortgages are still a huge rave among many home buyers who might not qualify for a
traditional fixed rate loan. Surely, those who are struggling to keep their finances stable will benefit
from the lower monthly payments they will have to pay for a certain number of years. When there’s a promise of better income in the future, it is only logical to steer clear of the higher interest rates that fixed mortgages offer. Although interest-only mortgages may seem to be the best answer for now, one shouldn’t ignore the fact that this type of loan is subject to a higher default risk in the future, or in short – you will soon face higher interest rates.
Why You Should Avoid Interest-Only Mortgages
If you’re not desperately wanting to purchase a home and you can still wait for your finances and credit score to build up, you need to stay away from interest-only loans because of:
1. Risk of Missed or Non-Payments
In traditional loans, you are paying your monthly interest that is computed against your principal loan amount. With your payments also come the reduction of your loan amount. With interest-only
mortgages, you may love the lower monthly interest payments for the first five years, BUT your principal loan amount will not be reduced for those years. Instead, you will be paying for the principal loan and interest rate, after the interest-only period is up, for the remainder of your loan term. Not many people can remain in a 30-year mortgage term and with the increase in future payments, you may run the risk of delayed payments or non-payment that can hurt your credit score.
2. Risk of Inflation
Interest-only mortgages run on a variable interest rate, which can rise or fall, depending on the current economic conditions. If you start paying the principal loan, which you can do anytime, the interest rate also resets. This means you can expect for a higher interest rate which can cost more than the interest of your fixed-rate mortgage. You might find your budget stretched to its limits when interest rates soar higher than you can ever allow.
3. Risk of Negative Equity
If you don’t make that effort to repay the principal loan amount, you will soon be faced with a negative equity where you will desperately pray for your home’s market value to increase. With the fall of real estate prices, you may actually be paying more than what your home is actually worth in dollars. When borrowers are forced to put up their homes for sale, they will have to find more money to pay off the remainder of the unpaid balance.
4. Difficulty in Refinancing the Loan
Lenders nowadays are stricter with their requirements in approving refinancing schemes. They need to see higher incomes, lesser loans, increase in home equity, and better credit score when it comes to helping you refinance your home. With interest-only mortgages, you will not be sure of being granted the refinancing you need for your home, or you may be given higher interest rates that make refinancing a costly option.
5. Risk of Losing Your Home
Because of higher monthly payments in the future, you run the risk of losing your home if you are earning seasonal income for the rest of your loan’s term. For this, you can lose your home when you miss your monthly payments, or your home may face foreclosure. If you don’t have enough money to pay off your closing costs, you may not even be able to sell your home.
In the end, you truly need to analyze your finances before you even rush off to your nearest lender to get an interest-only mortgage for your dream home. You must make a careful assessment of your budget and future earnings to know if this option is the right choice for you to take. You can also find plenty of free interest-only mortgage calculator online which will give you a rough estimate of what you will be paying for in years. You also have to consider your savings and expenses to see if the plan fits in well with your household budget. Patience is truly a virtue, where you may improve your credit score and build up your cash while you wait for the best, fixed-rate loan deals in town. Don’t Rush!
RESOURCES:
Stammers, Robert. “ Interest-Only Mortgages: Home Free or Homeless? “ 2009. Investopedia, ULC. http://www.investopedia.com/articles/mortgages-real-estate/08/interest-only.asp
California Loans. “ The Interest Only Mortgage Trap. “ May 2009.
http://www.californialoans.org/the-interest-only-mortgage-trap.html
Donev, Stef. “ 7 Reasons to Avoid Interest-Only Loans. “ 2009. Interest.com.
http://www.interest.com/mortgage/reasons_avoid_interest_only_mortgages.html
Caldwell, Miriam. “ Interest Only Mortgage. “ 2009. About.com.
http://moneyfor20s.about.com/od/shoppingforloans/g/Interestonlymor.htm
HSH Associates Financial Publishers. “ The Principal Facts of Interest-Only Mortgages. “ 2007.
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