Explanation

• During the first phase of an interest-only mortgage, you don't have to pay anything more than the interest due each month. However, you're free to pay extra each month, and that amount is applied to the principal balance. This interest-only period usually lasts 5 to 10 years. Afterward, you have to start paying off the principal, which means your monthly payments are going to go up--and by a lot.
  
  

Examples

• Say you take out a conventional 30-year mortgage for $150,000 at 6 percent interest. For the life of the loan, your monthly payment will be about $900, divided between principal and interest. (It's mostly interest at the start, but each successive payment contains more principal. Payments to principal become your equity in the home.) Now consider that same loan with a five-year interest-only period at the beginning. Your minimum monthly payment for those first five years is just $750. But after the interest-only period runs out, it jumps to nearly $970.
  
  

Benefits

• Some people can benefit from an interest-only loan. If your income is not steady, but rather comes in surges, such as from bonuses or commissions, you can take advantage of the low payment in lean months, then make extra payments on principal when you get paid. Or, if you're sure that your income will increase considerably in the future, an interest-only loan can help you get "more house" than you could afford on your current salary; when payments jump in the future, your income will have risen to match. Finally, financially savvy people might be able to invest the money they save and earn a high enough return that they would build wealth more quickly than they would by paying down the principal and gaining equity in the house.
  
  

Risks

• The risks are plentiful. Many people simply lack the financial discipline to make principal payments when they don't absolutely have to or to invest their initial mortgage savings rather than spend it. If you don't get the big salary increase you expected by the time the interest-only period ends, you can be stuck with a house payment you can't afford. And since you may not be building any equity in your home, an overall drop in home prices can leave you owing more than the house is worth. This happened to many people when housing prices began to collapse in 2006.
  
  

Trend

• After the housing collapse, lending standards for interest-only mortgages tightened considerably. Lenders and the government entities that regulate or underwrite them began requiring no-interest borrowers to have better credit scores, higher income and more assets. For example, Fannie Mae, a government-backed corporation that buys hundreds of billions of dollars worth of mortgages from lenders, announced in 2010 that it would accept interest-only loans only if borrowers could demonstrate that they would be able to meet the higher payments after the interest-only phase ends. Further, borrowers would need to make at least a 30-percent down payment and would need to have at least two years' worth of cash reserves.