Interest only mortgages and deferred interest loans are options to the normal way of paying mortgages and loans. They can be a powerful loan option when appropriate for your specific scenario. Here is a brief explanation of each.
Interest Only Mortgages and Loans
Interest only mortgages and loans enable you to pay only the interest for a specified period of time. You pay nothing towards the principal. There are options, however, that allow you to pay as much of the principal as you choose.
By taking this option, your monthly mortgage payments will be less than a normal repayment mortgage. Often significantly less, although the principal must be paid eventually. In the USA, interest only mortgages usually run for 5 or 10 years. You pay only the interest on the total mortgage or loan.
After these 5 or 10 years, your mortgage is amortized over the remaining period: 25 or 20 years in the case of a 30-year mortgage. It is obvious then, that with interest only mortgages you pay less in the first period and more in the second. The longer the interest-free period runs, the higher the payment for the final period.
Deferred Interest Loans
Deferred interest loans offer an alternative to interest only mortgages. With these, you pay an agreed minimum payment towards the interest each month – nothing towards the principal. You could therefore pay less than with the deferred interest mortgage.
However, if you pay just the minimum, the balance of the interest due for that month is added to the principal sum. So you pay less when you have less to pay, and more when you can afford it. If you pay the full interest, it is fundamentally the same as an interest only loan. The benefit is you can pay as much as you like when you have extra income.
If your income fluctuates monthly, such as if you have your own business, or depend on commissions for your income, then this is a better option that an interest only agreement. You pay what you can afford each month. The disadvantage is that you can end up owing more than you borrowed because your unpaid interest is added to the principal.
Who Benefits from Deferred Interest and Interest Free Mortgages?
If you can afford the total repayment – interest + principal – then do that. Try to choose a home that you can afford on that basis. Many people overestimate their future earnings, and find they cannot afford the final payment period.
However, if you know you will be earning more later, then an interest free mortgage or even a deferred interest loan may be of advantage to you. If are an ambitious newly-qualified professional, for example, and know you will be earning more in 5-10 years time, then these options are worth considering.
Here are some other situations where one or other of these options might benefit you:
You can use the money you save on your mortgage payment on an investment that offers a higher return than your mortgage interest rate. Since mortgage rates are generally lower than personal loan rates, interest free or deferred interest mortgages are more beneficial than the same arrangement with other types of loan.
If you intend selling within the 5 or 10 years. The principal sum paid in the time with a regular mortgage would be fairly low, so it would not make much difference to the balance you receive from the proceeds. This is particularly the case if you expect house prices to rise significantly over the next 10 years or so. Your equity will rise way beyond the significance of your principal repayments.
If you have a pressing credit card debt then the interest rate will be higher than that of your mortgage. Your cash is better spent reducing that debt than your mortgage loan. Why pay $200 each month to reduce a 5% debt when you can use it to reduce a 15% debt?
Interest only mortgages are beneficial if you expect to earn more a few years down the line. You also gain if you have higher interest debts to pay off and in some other circumstances. Deferred interest loans and mortgages offer you even more flexibility in your repayments. However they are not good for everybody, so check with your mortgage professional before making a decision.