There are many methods used to try to make a home more affordable. One of the most common is to eliminate or reduce the down payment. The other way is to lower the monthly payment.
The most common way of lowering monthly payments is to get a really good rate. There are also interest-only loans that save people money on their monthly payment for a period of time.
Quicken Loans doesn’t do interest-only loans, but we’ll go over what these are, their advantages and disadvantages, and the alternatives.
Interest-only loans have their advantages and disadvantages, but before we go any further, let’s start with the basics.
What’s an Interest-Only Loan?
An interest-only loan is one where you pay only the interest (hence the name) for a number of years at the beginning of the loan term, usually 10 years. During this period, your principal balance remains the same.
Once the initial timeframe rounds out, your loan is re-amortized, a fancy word that refers to payment recalculation, to include both principal and interest and have it all paid off by the end of the loan term.
Can You Get an Interest-Free Loan?
So we know about interest-only loans, but another thing people often ask about is interest-free loans. This is one case where what our grandparents told us about life is definitely true.
There’s no such thing as a free lunch and no such thing as a free loan, either.
Advantages of an Interest-Only Loan
There are a number of reasons people consider interest-only loans. For instance, it might make good financial sense. On a traditional 30-year fixed-rate loan, roughly 70% of the payment goes toward interest during the first six or seven years of the loan. If your interest rate is low, then you’ve borrowed money at a good rate.
Instead of paying down that low-rate loan, the extra money each month from making interest-only payments can be invested in something that would bring a higher rate of return. Depending on the loan amount, you could have access to thousands of dollars over the course of several years to invest or reduce high-interest debt, including credit card debt.
An interest-only home loan is sometimes considered an option for people who expect to be in their homes for less than the term of the interest-only period. The average homeowner stays in their home 10 years. As mentioned before, home mortgage payments are composed mostly of interest for the first years of the loan. Many homeowners like the option of making interest-only payments and using the extra money as they please – to save for college tuition, make home improvements, buy a much-needed new car, etc.
Also, while you have the option of only paying interest and that’s the only amount that’s due, you do have the option of making payments toward the principal as well if you want to.
Lastly, because mortgage interest is fully tax-deductible for those with loan balances of less than $750,000 (up to $1 million if you bought your home before December 15, 2017), there’s a good chance that your entire monthly mortgage payment is deductible if you’re only paying interest.
Disadvantages of Interest-Only Loans
For all their advantages, interest-only loans can also have significant drawbacks. Among these is the fact that if you only make the interest payments, when it resets and you start making principal and interest payments, you’re paying on the full principal amount.
There’s also the problem that if you’re used to only paying the interest and then your payment goes way up when principal is added, it can be quite a shock.
If you’re looking for a lower monthly payment, one alternative you might want to take a look at is an adjustable rate mortgage (ARM).
Adjustable rates could work as a nice alternative to an interest-only loan by giving you the option for lower payments while still paying down the principal on a regular basis.
How Does an ARM Work?
All ARMs start out with an initial fixed-rate period. Common timeframes for this are five, seven or 10 years. During this period, you get an initial interest rate that’s lower than the fixed rates available at the time because the market doesn’t have to worry about projecting out their return on investment against inflation over the entire term. The interest rate can change.
At the end of this fixed rate timeframe, your interest rate will adjust up or down once per year based on current market conditions. Depending on the investor in your loan, there are a couple of different indexes used. The index number is then added to a margin to get your final rate for the year.
If you’re still in the home when it’s time for the rate to adjust, you may be able to refinance into a fixed rate if you choose. Otherwise, you can let your rate move with the direction of the market.
I also want to note that if your rate does go up, there’s a cap on how much it can go up initially, in each subsequent year and over the lifetime of the mortgage. Your rate can’t go up indefinitely. You also might be ready to leave your home by the time it adjusts.
Advantages of an ARM
The primary advantage of an ARM over an interest-only loan is that you’re paying down a little bit of the principal with each monthly payment, which enables you to pay less in interest over time.
You also still enjoy a lower payment than a typical fixed-rate loan over the initial teaser period of the loan. This helps achieve some of the advantage of an interest-only payment.
Disadvantages of an ARM
The big disadvantage of an ARM is that the rate does adjust after the initial fixed period. Still, there are things you can do to minimize the impact.
Beyond switching into a fixed-rate loan as discussed above, you can also pay down the principal by making extra payments every month. That way, when your loan does re-amortize when the rate adjusts, your required monthly payment can be lower because you don’t have as much of the balance left. This lowers your monthly payment.
If you think that an ARM might be right for you, you can check out options for this and other loans online through Rocket Mortgage® by Quicken Loans. If you’d rather get started over the phone, you can give one of our Home Loan Experts a call at (800) 785-4788. If you still have questions, we can answer them in the comments below.
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