What is an Interest-Only Mortgage?
Due to the rising price of homes in Canada and the mortgage stress test, it has been challenging for Canadians to secure a mortgage. If you’re frustrated by the housing economy – you’re definitely not alone.
For these reasons, some Canadians are turning to alternative forms of mortgages to successfully purchase a home. One variation of a traditional mortgage is an interest-only mortgage. To learn more about what an interest-only mortgage is, how it differs from traditional mortgages and the pros and cons, continue reading below.
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What is an Interest-Only Mortgage?
As the name implies, an interest-only mortgage is a type of mortgage financing where the borrower only pays interest with their monthly payments. There is no principal repayment with an interest-only mortgage. The only way the principal balance will change is if the borrower makes extra payments.
Keep in mind that interest-only mortgages are usually structured with the option to make interest-only payments, it is not absolutely mandatory. This means that the borrower could make regular payments with the principal included and exercise their interest-only option when they face financial struggles. For example, a home buyer may incur an urgent home repair and decide to exercise their interest-only option in order to free up cash for the repair.
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The term of an interest-only mortgage is fixed and typically lasts between five and seven years. Once the term is up, most borrowers refinance their mortgage, begin to pay the principal of the loan or make a lump sum payment. If the borrower decides to start making principal payments, the amount will significantly increase.
On the surface, an interest-only mortgage sounds fantastic because your monthly payment will be lower without the principal amount. Keep in mind that the borrower still owes the principal amount, they simply are delaying the timing of principal repayment.
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Traditional Mortgage vs. Interest-Only Mortgage
An interest-only mortgage is still a mortgage and shares many qualities with traditional mortgages. However, the interest-only component ignites some differences too. Let’s explore the similarities and differences below.
- Used to Purchase a Home. Since many don’t have the cash available to purchase a home outright, they turn to a mortgage product. A traditional and interest-only mortgage covers the cost of a home that the borrower cannot cover themselves.
- Involve Regular Payments. Both traditional and interest-only mortgages require you to make payments on specific dates. While the amounts vary, you cannot get around making timely, full payments otherwise your credit score will suffer.
- Avoid Immediate Burden of Traditional Mortgage. An interest-only mortgage allows you to ease into the burden of homeownership and mortgages. With a traditional mortgage, it all comes at you at once.
- Principal Repayment Timing. Both a traditional and interest-only mortgage requires you to repay the principal. The difference is timing, a traditional mortgage involves immediate principal repayment whereas an interest-only mortgage involves delayed principal repayment.
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Who Should Consider An Interest-Only Mortgage?
Interest-only mortgages have a unique structure that is only favourable in some circumstances. Below is a list of scenarios where an interest-only mortgage is desirable.
- You’re purchasing and selling the property in a short period of time.
- Able to afford a large payment increase in the future in exchange for a lower payment now.
- You do not earn a flat salary and have a variable salary instead.
- Able to earn more with your money elsewhere in the short term.
- You’re a first time home buyer who is not accustomed to making mortgage payments and other homeownership costs.
Pros and Cons of an Interest-Only Mortgage
Before making your decision to proceed with an interest-only mortgage, it’s important to consider the pros and cons. Knowing the advantages and disadvantages can ensure that the choice suits your personal financial situation best. Let’s explore the pros and cons below.
- Low Monthly Payments Initially. Monthly payments are low during the beginning of the mortgage term.
- Earn Elsewhere. Using the extra cash that isn’t being put toward the principal amount of the mortgage, you can hypothetically earn more elsewhere.
- Little Value Appreciation. Some use interest-only mortgages with the expectation that the property’s value will increase and they can turn a profit by selling it in a few years. However, if the home doesn’t appreciate in value, or worse depreciates, the borrower could wind up in a bad financial position.
- Don’t Use Idle Money Effectively. With a reduced mortgage payment, it’s easy to overspend. The idle money should be invested elsewhere and eventually put toward the mortgage principal or other homeownership costs.
- Risk of No Income Growth. Some choose to use an interest-only mortgage with the expectation that their income will grow in the future. If this doesn’t happen, the borrower could end up in a tough financial situation.
- Unable to Afford Principal Payments. When the time comes to make principal payments, many aren’t able to afford them. In addition, most aren’t good at putting extra money toward their mortgage. This concept is better known as “payment shock” because it certainly can be a shock!
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Is An Interest-Only Mortgage Right For Me?
As you can probably tell, an interest-only mortgage is a very unique financial product and is rare for people to use regularly. Despite this fact, that doesn’t mean an interest-only mortgage it’s not right for you. Before making a decision to use an interest-only mortgage, be sure to consider the risks and have confidence that you won’t hurt your finances as a result of them. If you believe that your financial situation would benefit from using an interest-only mortgage, then go for it.
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