Interest Only

A mortgage is interest only if the scheduled monthly mortgage payment consists of interest only. Remember that the scheduled monthly payment is the payment the borrower is required to make. In addition, borrowers have the right to pay more than interest if they want to.

If the borrower exercises the interest-only option every month during the interest-only period, the payment will not include any repayment of principal. The result is that the loan balance will remain unchanged. Interest-only mortgages are for borrowers who have a valid use for a lower initial required payment, and are prepared to deal with the consequences. Borrowers with fluctuating incomes may value the flexibility the IO mortgage gives them. When their finances are tight, they can make the IO payment, and when they are flush they can make a substantial payment to principal.

Ask yourself whether you are disciplined enough to make the payment to principal when you aren’t obliged to. It is common for families to begin with a starter house, then move into a more expensive house as their incomes rise. This process of "trading up" carries high transaction and moving costs.

In the short term, this will cause a cash flow strain, but the IO mortgage may make it manageable. Ask yourself whether you are comfortable with the risk that the expected higher income won’t materialize. For most homeowners, paying down mortgage debt is the most effective way to build wealth. Nonetheless, some may build wealth more rapidly by investing excess cash flow rather than paying down their mortgage. For this to succeed, their return on investment must exceed the mortgage interest rate, since that rate is what they earn when they repay their mortgage.

A valid example is the young borrower with a long time horizon who invests in a diversified portfolio of common stock. This should generate a yield of 9% or more over a long period. Another are business owners who might earn a high return investing in their own businesses. 

Ask yourself whether you really will invest the excess cash flow, as opposed to spending it; and whether you have a firm basis for believing that your investments will yield a return higher than the mortgage rate. I don't recommend it as a wealth-building strategy for most borrowers.

Interest-only (IO) is the instrument of choice in a quick turnover situation if you are trying to maximize the amount of house you can buy, and are limited by your income. The IO option lowers the required initial payment, which allows you to qualify for a larger loan amount.

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