Fixed Rate Mortgage vs. Interest Only Mortgage

Pros and cons of an interest only mortgage

Every homebuyer has different financial needs and priorities. Due to the varying needs of consumers, there are many kinds of mortgage products on the market. Some homebuyers prefer a traditional fixed mortgage, while others would rather have smaller interest-only payments. Each loan fills a different niche and may not be for every buyer. In the case of an interest-only mortgage, the principal balance doesn’t get reduced so you can have more affordable payments. As with any monetary instrument, there are pros and cons to each type of mortgage.

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Your conventional mortgage loan

Mortgages, which are loans secured against real estate, come in all shapes and sizes. A conventional fixed rate mortgage tends to be a popular choice among consumers. With a fixed mortgage, your payments will stay the same until you have paid back the loan entirely.

Typically, your monthly payment is the sum of two parts: interest charges and principal repayment. Interest is what the creditor charges for the money you want to borrow, while principal works to pay back the borrowed amount.

By obtaining a fixed rate mortgage, homeowners can lock in their rate for up to 30 years or more. Since interest rates tend to fluctuate, this can provide a lot of security for homeowners. In exchange for the stability, a fixed rate mortgage can be more costly when compared to other loans.

The interest-only mortgage

With an interest-only mortgage you don’t reduce the principal balance. You will always owe the same amount of money regardless of the payments you make because you are only paying the interest. As a result, you can save a ton of money on your monthly mortgage payments.

Typically, the monthly payments can be reduced by a few hundred dollars, which means huge savings over a 5, 10, or 15-year window.

For example, if you were to borrow $250,000 at 4.5%, over a 30-year term, your fixed monthly payment will be $1,266. By contrast, if you borrowed $250,000 at 4.5%, over a 30-year term with 5-year interest-only payments, the monthly due changes to $973. This saves you $329 per month and $3,948 per year. After four years you’ll have saved a total of $15,792.

As you can see, the reduction in payments is quite impressive – but this comes at a price (more on this later).

You can get an interest-only payment plan for any home loan. However, interest-only products are generally administered for a limited time period. It’s most common to see the interest-only offer for five to fifteen years before the loan starts fully amortizing. That means the payments will eventually increase, but you’ll also begin to pay down your principal balance .

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Interest-only considerations

Interest-only payment plans can save you money in the short term but may end up costing more in the long run. When the interest-only period ends, your monthly payment may jump up more than what you were saving each month. There is no guarantee that your interest-only plan will convert to fixed plan at the same rate. More often than not, the rate will increase and create much larger monthly payments.

Other times, an interest-only mortgage will convert to an adjustable mortgage with yearly rate adjustments. For many homebuyers, this can be both shocking and alarming if rates rise while you have the interest- only plan. For this reason, it’s crucial to read the fine print on your offers.

An alternative option is to sell the home or refinance before the end of the introductory period. However, this decision will come with many stipulations. If your home decreases in value you may have a difficult time to pay off the principal balance.

There is also no promise that you will be a qualified applicant when it comes time to refinance. Mortgage regulations are continually changing, while interest rates continue to fluctuate. It is entirely possible to make it through your interest-only period to find out the market has shifted tremendously. In these instances, refinancing can be tricky, expensive, or impossible.

Which loan is right for me?

While it is imperative to assess what you can afford to pay each month, you'll have to dive deeper to find the best course of action. Your decision should factor in your budget, equity preferences, future plans, and income projections.

Your budget. When buying a home, you’ll have to consider what you can afford. Many homebuyers choose an interest-only payment plan for the lower monthly payment. If a person is a first-time buyer, it’s likely that he or she can use some extra cash to furnish the place. Other individuals in later stages of life may have kids to send to college or elderly parents that need financial assistance. In these times, it can be helpful to roll back your monthly obligations until things settle down for you. However, if you have a stable monetary situation, a fixed mortgage is typically a better option.

Equity preferences. Your principal contributions should be an essential part of your decision. With a fixed rate mortgage all of your payments will contain some amount of principal. After 5-years you’ll likely have built up some equity in the home. This can put you in a better position to sell or refinance if rates become more favorable. By contrast, you don't pay down the balance on an interest-only mortgage until it starts fully amortizing. This can put some homeowners in an uncomfortable position if specific factors come into play.

Future plans. The amount of time you intend to live in your home may affect your loan choice. If you know that you will move in a few years, interest-only plans can provide the best payments for a temporary situation. However, if the future is not as clear, a fixed mortgage offers borrowers competitive rates for many decades into the future.

Income projections. The amount of money you expect to make in the future should be an crucial aspect of your decision. Interest-only payments can change dramatically once the loan becomes fully amortizing, so you'll need to make enough to manage your payments. Otherwise, you could face credit problems and foreclosure. Additionally, earning a higher income in the future can make you a more qualified applicant. If you are ambitious with a bright career ahead of you, an interest-only mortgage may not be such a gamble. By contrast, if you think things at work won’t change over the coming years, its best to go with a fixed mortgage.

As you can see, there are many things to account for when buying a home. You've already taken an important step by visiting this page. By using the calculator on this page, you can model how each mortgage will work out for you.

Using the calculator

The calculator is very straightforward to use. You’ll have to add your financing offers to the system, to illustrate what your mortgage payments will be. Let’s review this together.

Step 1. In the first part of the questionnaire, called fixed rate mortgage, you can add your financing needs. Include the mortgage amount, the term length, and the interest rate for the fixed offer. Interest rates can vary based on many factors such as the loan amount, the type of home; it's location, and your credit profile.

Step 2. In the second part of the questionnaire, you can document your interest-only offer. First, you should add the interest rate. Then, if you intend to pay down your principal, you can add the monthly amount you want to contribute next to prepayment. Most homeowners choose not to make extra principal payments. However, even a small amount continually added to the principal can put you in a better position to negotiate your terms in a few years.

Once this is added to the calculator, you can view your results in the form of smart prompts, graphs, and tables.

Your results

Immediately to the right of the inputs, you can view the monthly payment for both the fixed rate and interest-only mortgage. If you’re wondering what the exact savings are, check out the smart prompt a little bit further down. The smart summary will tell you how much you can save each month with an interest-only mortgage.

For more detailed information, you can view the four integrated reports. The first tab is a simple bar graph comparison of the monthly payments.

The second tab provides a schedule of the all the loan payments. Here you can see how each payment affects the balance on the loan. As you pay down the principal balance, your equity in the home increases.

The third tab is a summary of the savings you will receive with an interest-only mortgage. Here you can observe your initial mothy savings, yearly savings, and savings after four years.

Finally, the last table provides a comprehensive analysis of both loan options. This report compares your total payments after year one and four, along with the total of all your payments. If you look carefully, you can see that you will end up paying more interest on the interest-only mortgage, while being left with a massive payoff at the end of the term.