Most home loan payments are split into two when they reach the bank; a small part reduces the equity, and the rest pays the interest. At least, that?s the way it used to work. A new type of mortgage has been designed to allow the monthly mortgage payment to be as low as possible, by requiring only the payment of interest.
This means that if you pick an interest only option, every month you pay your loan, the loan balance stays just the same; it never goes down. Just about all mortgages allow you to pay off a higher balance than the minimum, and interest only loans are no different; you can pay more if you like.
Interest only loans were based on the theory that it did not matter that the principal was never reduced, because when the home was sold, the additional value would allow the borrower to pay off the loan. It used to be that homeowners accrued equity by paying off part of the loan, and by the additional value of the house.
However, developments in the real estate market mean that this kind of increased value is no longer a given, so any equity has to be built by paying down the principle. There are cases where interest only loans are a good solution. This might be good option as long as it were a temporary situation.
Let us say there is a situation where one partner is not working or only working part time while he completes school. Since, in theory, the student would eventually complete his studies and get a good job, keeping the home loan payment low during this period and ramping them up later makes sense.
Another case might be that of a wage earner with sporadic income that changes from one month to the next. Such an example might be a project worker who is only paid when the project is complete. Keeping payments low in the months when income was low and then paying into equity when the windfall came would be a sensible decision, as long as the discipline was there to make the extra payments.
But eventually, the borrower should make sure that those principle payments get caught up on. Using a traditional loan mechanism, if the home value is lower, flat or only increases slightly, the margin of equity that the borrower deposited will cover the difference. If you only pay the interest each month, you will never reduce the principle, and if the home sales price is lower than the home loan, you will not be able to pay off the loan.
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