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The basics of how an interest-only mortgage works

An interest-only mortgage can sound appealing for a potential homebuyer because it is a mortgage loan that requires that you pay only interest — no principal — for the first several years. After that, you pay the principal and interest.

Interest-only mortgage loans provide borrowers with lower mortgage payments during the initial few years of the loan. Review the details about interest-only mortgages to decide if one would be right for you or if you should try to find the best mortgage rate for a traditional, 30-year loan.

How do interest-only mortgages work?

For a certain period of time at the beginning of the loan — usually three, five, seven or 10 years — you pay only interest. Some interest-only loans come with a fixed interest rate for the first few years, but that varies among financial institutions. After your interest-only period ends you pay interest and principal for the remaining life of the mortgage.

For example, say you take out an interest-only, 7/1 adjustable-rate mortgage loan. You’ll pay interest only for the first 10 years of the loan and the interest rate will be fixed for the first seven years.

In year eight, the interest rate can start rising by up to 1 percent per year, but you’ll still be paying only interest. Once you reach the 10-year mark, you’ll begin paying principal and interest. Because you paid only interest for the first 10 years, the principal will be amortized over the last 20 years of the loan.

Interest-only mortgage advantages

Like any financial tool, an interest-only mortgage has pros and cons. Review these four benefits to decide if you’re a good candidate for this type of home loan:

■ Interest-only mortgage loans can free up cash you can use for other things during the first 10 years. Some people invest the money they save, hoping to earn a higher rate of return.

■ You might take out an interest-only home loan if you earn a relatively low base salary but get a large, annual bonus. When you get your bonus you can make an optional principal payment.

■ If you have a substantial income but foresee a big expense in the near future — like college tuition — using an interest-only loan to refinance your house might help you manage that cost.

■ You’ll get a tax deduction for the entire amount of your monthly payment for the first 10 years if the loan is on your primary residence because the interest you pay on your primary mortgage is tax deductible.

Interest-only mortgage disadvantages

An interest-only mortgage could be ideal for some, but this kind of home loan does come with some drawbacks. Review these three cons to decide if any is a deal-breaker for you:

■ During the first 10 years of the mortgage, the only equity you’ll gain in the house is the increase in its value, if any. When you borrow $250,000 with an interest-only mortgage, 10 years later, you’ll still owe $250,000.

■ If you’re paying mortgage insurance, you’ll continue to pay it until you have enough equity in your home, which won’t be until you’ve been paying both principal and interest.

■ Your monthly payment will go up substantially after the interest-only period. The principal portion you’ll pay after the 10-year, interest-only period will be 50 percent more than the principal portion on a traditional 30-year payment because you’ll be paying off the principal in 20 years instead of 30.

Things to keep in mind about interest-only mortgages

Interest-only mortgages can be an effective tool in the right circumstances, but this type of home loan was part of the reason for the Great Recession of 2007 to 2009. Now, regulators keep a very close eye on them — these loans typically require a much larger down payment than traditional mortgages. For interest-only mortgages backed by Fannie Mae and Freddie Mac you must make a down payment of at least 30 percent, which is significantly higher than as little as 3 percent on a traditional 30-year mortgage. For this reason, you typically won’t have to pay for private mortgage insurance on an interest-only mortgage.

You might think an interest-only loan will enable you to qualify for a more expensive house than a traditional mortgage, but this isn’t always the case. Most interest-only mortgage lenders qualify you based on your ability to handle the highest monthly payment you’ll have to eventually make on the loan. Interest-only loan rates can differ from the rates charged for a traditional mortgage, but if your credit score is high you might be able to find comparable rates, so shop around for the best mortgage lender.

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