For most homeowners, paying down mortgage debt is one of the most effective ways to build wealth. However, there are homeowners who choose to enter into mortgage loans that only require payment be made on the loans interest and not on both the interest and principal. These are called “interest only” mortgages and they have both pros and cons that should be weighed by a fully informed borrower before exercising this loan choice.

An interest only loan means that the terms of the loan permit you to make monthly interest only payments for a period of time specified in the loan. During that period, the loan balance is not reduced because payments are not applied to the principal. Typically, an interest only period may run from 5-10 years. After that the loan converts and the monthly mortgage payment is raised to a fully amortized level—that is paying both interest and principal.

The new payment will be larger than it would have been if the loan had been fully amortized in the beginning. However, at the end of the 5-to-10 year period the loan might be refinanced for a lower interest rate, or the home may be sold and the increased payment avoided altogether. It is also likely that the borrowers will be earning more than they did at the time of the purchase and can easily make the increased payments.

It should be noted that some interest-only loans never convert and at the end of 30 years require a substantial balloon payment for the principal balance. If that is the case, the borrower must have the funds for the balloon payment or be qualified to refinance. Failure to meet either of these options could lead to the loss of the property.

What are the upsides to the interest only option? First, the monthly payment is less. That provides additional leverage to buy a larger home, or to buy the same home with less money down. Another advantage is that with reduced monthly cash flow a borrower can pay more to bring down the loan balance and qualify for a more expensive home.

The downside is the lack of equity growth for the homeowner. In a market such as we have on Maui, which has been experiencing appreciation, equity can still be acquired as a result of that appreciation. However, in an area with a down market, the value of the note goes down if it has to be sold.

An interest only loan can be a useful tool among the options available to today’s consumers. Many factors will influence the decision to exercise that option. A consultation with your professional mortgage broker can help in this process and ensure a complete discussion of the issues before any final decision is made.

Premiere Mortgage has offices in Kihei and Kahana. Tricia Morris may be reached at 874-8800.