Interest Only Mortgages: Are They Haunting Your Finances?

By Tammy Trenta, MBA, CFP, CTC, CEXP, Founder and CEO - Family Financial

It’s just like clockwork.

When the weather cools and pumpkin spice becomes the main character, we know what’s around the corner - candy, costumes, and creepiness. Halloween is a scary time of year, but we don’t mind feeling a little afraid; it’s only pretend, after all.

But the clock is also ticking for homeowners who took on interest-only loans during the past decade. For those who’ve grown accustomed to paying just the interest - and historically low interest, at that - a looming reset date (the date when principal payments kick in and interest adjusts to current market rates) is as terrifyingly real as a ticking time bomb. The jump-scare of a doubled, tripled, or even quadrupled monthly payment figure could make the strongest household budget R.I.P. 

Needless to say, if you’re holding a loan like this, it’s critical to start planning ahead so there are no unpleasant surprises. With interest-only loans, borrowers pay just the interest at a set rate for an introductory period of three, five, seven, or ten years. After the introductory period, the rate is recalculated and principal payments are included in the monthly bill.

These loans are usually less problematic for those who want to live in a home for a short period of time. But for those who plan to stay, the allure of low initial payments can set the stage for serious financial hardship. When borrowers promise themselves they’ll take an interest-only loan and save the difference, often, these plans fail to materialize. And when rapid inflation meets higher interest rate resets, borrowers could be on the hook for steep principal and interest payments.

Given that the interest-only loans dished out over the last decade are resetting in a dramatically higher interest rate environment, there are plenty of homeowners with conundrums like the following:

Mark took on a $500,000 mortgage in 2020 with a three-year ARM at a 2.25% interest rate, and is currently making monthly payments of $937.50. But if Mark’s mortgage rate were to reset today, those payments would jump to nearly $4,000 - which could be the difference between sinking and swimming. If you face a similar dilemma, you might want to weigh the pros and cons of the following 4 common scenarios:

1. Selling the property

If you’re staring down a substantial payment increase, you might be tempted to sell your property. But this is not as straightforward as it sounds, because property values have skyrocketed, too.

In the example above, Mark’s property value grew to $1 million. Selling would yield a substantial profit, but where will Mark and his children move? The current housing market is plagued by low inventory and rising prices, which makes it tough for buyers looking for an even trade - more so for those looking to trade up.

Another drawback is that when you’re above a certain threshold ($250,000 for single taxpayers and $500,000 for joint), real estate profits may be subject to capital gains taxes.

2. Paying down the principal

Others consider aggressively paying down the principal to reduce their monthly payments when the interest-only period expires. 

But think carefully: is it wise to pay down a 2% loan today when you could invest the money instead? Are you still benefiting from the mortgage interest deduction? It's crucial to consult with a financial advisor to determine the best approach for your situation. Assess whether investing the difference or even parking the funds in a money market account could be a more favorable option.

3. Refinancing

Whether you’re able to knock down your principal or not, you could consider refinancing your loan at prevailing interest rates. A new loan may or may not have a higher rate, but depending on how it's structured, perhaps you could negotiate a more manageable monthly payment going forward.

4. Adjusting your expectations

If you're willing to downsize, you should see more flexibility in your budget. And if not, you may need to bite the bullet and revisit that budget or find ways to increase your income to make the higher payment work.

Whatever you decide, it’s essential to be proactive and to be sure you fully understand your loan terms; you can request a closing disclosure statement that outlines the terms of your specific loan program. Carefully assess your situation and explore all options. The clock may be ticking, but early planning and informed decision-making can make the transition a little less terrifying.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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