Benefits

• Some banks allow the buyer to pay only the interest on the mortgage, not the principal. The buyer will still make a payment each month, but it will be smaller than the total payment on a mortgage that includes a principal payment. Because an interest-only payment is lower, the buyer can afford a larger or fancier house.
  
  

Considerations

• When a buyer takes out an interest-only loan, the buyer is not paying off the outstanding mortgage, so the buyer does not gain equity by paying down the principal. The buyer can only gain home equity if the value of the home increases, and the buyer will have negative home equity if the value of the home drops. The goal of a buyer who takes out an interest-only mortgage is to sell, or flip, the house to another buyer after the house value increases.
  
  

Mortgage Interest Deduction

• Both interest-only and repayment mortgages qualify for the mortgage interest deduction for federal income taxes. This deduction applies to the interest payments on the mortgage, not to the principal payments. A home buyer who makes a smaller payment because the mortgage is interest only will receive the same size income-tax deduction as a buyer who makes a larger payment that covers principal.
  
  

Risk

• A repayment mortgage is safer than an interest-only mortgage. The buyer is paying down the principal and will eventually pay off the mortgage, and may have positive equity even if the value of the house drops. The bank may have the right to convert an interest-only mortgage into a repayment mortgage if the value of the house drops beyond a certain point, depending on the contract.
  
  

Option ARM

• An option adjustable rate mortgage, or an option ARM, gives the home buyer a choice to treat the mortgage as either an interest-only mortgage or a repayment mortgage. The home buyer can make the full payment, including principal, in one period, and make a smaller payment that only covers interest in the next period. An option ARM may also allow the home buyer to pay off part of the principal that is due with a mortgage payment instead of all of it.