Interest-only mortgage payments may initially sound like a good idea. As the name suggests, you’re paying only the interest, which means more available cash for other investments you might be interested in, like purchasing stocks or bonds. However, the concept can be misleading. By making interest-only mortgage payments, you’re not actually reducing the principal balance of your loan. This means you’ll still owe the principal amount later on.
The standard advice: tread carefully.
Your banker might highlight the benefits of interest-only mortgages. But like most financial products, there are risks involved. Some experts believe that interest-only mortgage payments are no more advantageous than a traditional mortgage. Much depends on your liquidity (how much cash you have and your net worth), payment schedules, and your money management skills.
Nature of Interest-Only Mortgage Payments
What might initially appear to be a benefit could later become a disadvantage over the course of the loan. In regular or traditional mortgages, the first few years of payments are heavily skewed toward paying off interest, with only a small portion going toward the principal. For example, if you pay $800 per month on a traditional mortgage, about $700 of that might go toward interest, while only $200 is applied to the principal balance. With an interest-only mortgage, you save $200 by paying only the interest.
But is saving $200 a month for the first few years really a benefit? One thing is certain: deferring principal payments today could mean paying more interest later.
Historically, interest-only mortgages were offered by lending institutions to well-off clients who had sophisticated investment knowledge. These individuals would use the funds saved by not paying down the principal to invest in stocks or other high-return ventures. The idea was to use the cash to make a profitable investment, and when those investments paid off, they would make a lump-sum payment toward the mortgage. Essentially, these investors delayed mortgage payments to maximize short-term profits, leveraging their cash to build their asset base.
Sounds like solid money sense, doesn’t it? Absolutely.
But let’s consider the other side of the coin. Let’s assume the investor accurately timed the stock market and executed his strategy flawlessly. What happens if the company goes under and the stock value plummets? The outcome could be disastrous: not only would they still owe the mortgage principal, but they could also find themselves deeply in debt because their investment went south.
Like we said, tread carefully.
Smart investors will resort to interest-only mortgages if they are confident their investments will yield returns and they have enough resources to weather a temporary downturn.
Interest-only mortgages used to be reserved for sophisticated investors, but today they’re more common, with many people opting for this option with the approval of their bank.
Never Say Never
One important thing to remember is that interest-only mortgage payments don’t last forever, even with a fixed-rate mortgage. Some banks may allow interest-only payments for a specific number of years—possibly up to half the total term of the mortgage. However, policies vary, so it’s important to clarify this with your lender to avoid surprises when your mortgage statements arrive.
Interest-only mortgages were originally designed to accommodate cash flow or alternative investments. However, this began to change during the housing boom. As demand for housing surged, more people sought to buy homes, even if they couldn’t afford a large down payment. To meet this demand, lenders began offering products like interest-only mortgages, allowing more people to enter the housing market.
What happened next?
Lenders saw the housing demand as an opportunity to lend more money, putting homes within reach of those without sufficient down payments. This expanded their client base and made homeownership more accessible to many people, even those with modest resources.
If the buyer has sufficient resources, there’s generally no issue. But when a potential buyer lacks the minimum down payment and opts for an interest-only mortgage, they’re essentially buying more debt. This puts them into the “debt-leverager” category—individuals who are eager to take on more debt without fully considering the long-term consequences.
Interest-Only Payments: Risks
Leveraging debt is both a science and an art. It can yield substantial returns if done wisely, but for the less experienced, it can be risky. Homebuyers using debt leverage—such as with interest-only mortgage payments—might be tempted to buy an expensive home with a large mortgage. They might assume that their income will always be sufficient and that their property will appreciate in value. The problem arises when they fail to pay down the principal: without equity, their financial security becomes uncertain.
What if the market doesn’t appreciate as expected? Without equity in the home, these buyers could face significant financial problems down the road.
The risk with interest-only mortgages is that by not paying down the principal, homeowners aren’t building equity, which is essential for long-term financial stability. They may be gambling on the housing market’s appreciation, but markets are unpredictable, and home prices don’t always go up as anticipated.
Furthermore, down payments required for home purchases have been dropping. Just a couple of decades ago, Canadians typically needed a 20% down payment. Today, it’s possible to purchase a home with as little as 5% down. In the U.S., down payments have fallen from 10% in 1990 to about 3% in 1999, encouraging more people to enter the market.
What can result from interest-only payments? If the property doesn’t appreciate in value, or if the buyer faces financial hardship, they could end up selling their house for much less than they paid.
Here’s another risk: What if interest rates rise and the interest-only mortgage is tied to a variable or adjustable rate? How long can the borrower stay afloat in such a situation? Will they have enough money to start paying down the principal? You might argue that interest rates are currently low and may stay that way for a while. But as history has shown, interest rates can and will rise over time.
For example, if your interest-only payments are $800 a month and you have an adjustable-rate mortgage, an increase in the prime rate could raise your interest rate by 1%. Instead of paying 5.1% interest, you might find yourself paying 6.1%. Your $800 monthly payment would increase accordingly.
Interest-only Payments: Not All Bad News
Despite the risks, interest-only payments aren’t inherently a bad option. They’re ideal for individuals who are prudent investors and can identify good opportunities in other types of investments. For borrowers who manage their finances well and want to accumulate assets instead of more debt, interest-only payments can be practical.
Another benefit is that by saving money on principal payments, you could use the extra cash to renovate or improve your property, which could increase its value. For example, saving $200 per month over a year adds up to $2,400—enough for a basement renovation, new kitchen cabinets, or minor upgrades to increase the home’s marketability when it comes time to sell.
The money saved could also be used to fund your retirement or for your child’s education. As we all know, investing in education is one of the best investments you can make in life.
