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Interest Only Mortgages

There are usually two types of mortgages that you can use to finance a property purchase. One is a traditional mortgage, in which you immediately begin to pay the principal and interest payments. The other is an ‘Interest Only Mortgage’ which gives you the option to make interest only payments for a set period of time, after which the mortgage enters the repayment period and both principal and interest payments are made to repay the loan.

Interest Only Mortgages are usually a better option for those who plan to resell their property fairly quickly, or for those who do not have a fixed income and may need flexibility in their monthly payments.

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    What is an Interest Only Mortgage?

    An interest only mortgage is a loan in which payments are only made on the interest and not the principal for a set period of time, usually between 7 to 10 years. After this period, both the principal and interest payments are made towards repayment. The repayment period usually lasts 20 years for a total 30 year loan period. Interest Only Mortgages are only offered by private lenders, not banks. Because banks are federally regulated, the mortgages they offer are forcibly amortized, meaning the principal payments must be consistently made in order to protect both the lender and the borrower.

    How is an Interest Only Mortgage different from a traditional mortgage?

    When you take on a traditional mortgage, you immediately begin making payments towards both the principal and the interest of the loan for the duration of your mortgage agreement. An Interest Only Mortgage is unique because it has two seperate payment periods. For example, with a 25 year Interest Only Mortgage you have the option to pay only the interest in the first ten years. After this time, the repayment period begins, during which you pay both the interest payment you were already making, and the principal payments to pay down the loan.

    Who would benefit from an interest Only Mortgage?

    There are certain situations in which getting an Interest Only Mortgage is more advantageous to a borrower than a traditional loan. For instance, someone who is planning to resell a property that they recently purchased in a short period of time would find an Interest Only Mortgage more suitable for their needs. Interest Only Mortgages are also a good option for people who experience frequent fluctuations in their monthly cash flow and need significant flexibility in their mortgage payments. There are also options for those who are denied mortgages at banks to be able to apply for Interest Only Mortgage, however, lenders who are aware of this will typically increase mortgage rates for lack of competition.

    Tips for Getting a Interest Only Mortgage

    Because the burden to prove eligibility is greater on self-employed individuals, it pays to be well prepared before applying for a loan. The following should be considered before going into apply for a Self-Employed Mortgage:

    How to qualify for an interest only mortgage

    Interest Only Mortgages have a much higher standard for qualifying than traditional mortgages because there is an expectation that the borrower will ultimately be able to pay down the principal when the repayment period comes. The standards for an Interest Only Mortgage include:

    • High Credit Score: A high credit score is necessary as it gives lenders confidence in your credit decisions
    • Cash Reserves: Greater reserves of cash on hand and/or assets which can be used for payments when necessary
    • Higher Income: Higher than average household income
    • Affordability: Able to match interest payments if loan resets at a higher rate

    Benefits of an Interest Only Mortgage

    There are several benefits to an Interest Only Mortgage which vary depending on your financial situation and what you intend to use the investment for. For example, if you are a first time home buyer, the lower monthly payments which come with Interest Only Mortgages can significantly alleviate the financial impact with your first major property purchase.

    By being able to choose how much principal overpayments you make each month, you can have significantly greater financial flexibility when you need it.

    For example, a 30 year loan of $500,000 with an interest rate of 4.5% would yield payments of $2,533.43 every month. This covers both principal and interest. An interest only payment on the other hand is $1,875, meaning that you would save $658.43 every month with an Interest Only Mortgage.

    Other benefits to an Interest Only Mortgage include:

    • Being able to make flexible payments on the principal if your earnings are not static
    • Interest payments are tax deductible
    • The ability to divert funds for other emergency needs
    • Being able to buy a home without the immediate stress of large payments

    Disadvantages of Interest Only Mortgages

    Canadian banks are federally regulated and therefore are not allowed to offer Interest Only Mortgages. These regulations mandate that payments made on any mortgage go towards both the principal and the interest. Otherwise there is a risk that when the loan enters the repayment period, the borrower will not ultimately be able to pay off the principal loan. This is why Interest Only Mortgages are only available from private lenders.

    Other disadvantages include:

    • Payment Shock: the repayment period begins for interest and principal loans, some borrowers are not able to keep up with the sudden increase in bills
    • Property Depreciation: If the property you purchase depreciates in value rather than building equity, you might end up owing even more to the borrower, which will ultimately the loan even more difficult to pay back
    • Higher Interest Rates: Because Interest Only Mortgages are only available through private lenders, those who are unable to acquire a loan through traditional means may be forced to pay exorbitantly high interest rates for lack of a better option, which may make repayment even more difficult to manage

    Where can I get an Interest Only Mortgage?

    Because Interest Only Mortgages aren’t available through banks, you have to find a private mortgage lender or a brokerage that is willing to finance your purchase.

    Private mortgage lenders assess individuals on a case by case basis and will potentially offer loans that banks would otherwise reject. Make sure you closely evaluate the repayment period and fees from different lenders before choosing one.

    Is it harder to get a mortgage if I am self employed?

    Obtaining a Self-Employed Mortgage can be more difficult than a traditional mortgage as the borrower has to take extra steps to prove to the lender that they are capable of maintaining regular payments on their mortgage. It is possible that depending on the financial institution, that Self-Employed Mortgages are not offered at all. Where they are offered, there is also the chance that banks will significantly increase the interest rates for these loans, making them a more difficult consideration for borrowers. To give a better chance at being approved, lenders are expected to offer a large down payment, up to 20% or higher, as well.

    Another difficulty associated with Self-Employed Mortgages is the lack of a T4. A full time Employee can provide proof of income through a simple T4, however a self-employed individual must provide a stated income form, which shows the amount the potential borrower claimed to have earned, and then must provide documentation which can prove the stated amount is accurate.

    Lenders will also apply the Debt Service Ratio when considering your eligibility for a loan. This is a measurement which determines your ability to maintain regular payments on a loan after all your financial responsibilities have been considered. These include monthly bills, car loans, lines of credit, student debt and any other loans.

    If after considering these other factors the bank is confident that you are able to meet their requirements for regular payments, you will be eligible for a loan.

    Commonly Asked Questions

    An Interest Only Mortgage temporarily allows you to pay only the interest cost without having to immediately pay down the principal. Once the interest only payment period ends, you then pay both the remaining principal and the interest payments on the mortgage until the end of the loan period..
    There are various situations in which an Interest Only Mortgage can be more advantageous for a borrower, as compared to a traditional mortgage. Examples of this are: A borrower who plans to resell their property within a short period of time, or a first time home buyer who wants flexibility in their initial payments.
    In order to be eligible for an Interest Only Mortgage, you need to; prove to the lender that you can maintain higher payments if the loan changes to a higher rate, be able to give at least 20% for your down payment, and have a minimum credit score of 720.
    It is possible to make overpayments on an Interest Only Mortgage. Some people prefer to get Interest Only Mortgages so that they can make principal payments which match their current financial situation, rather than a fixed amount in a traditional mortgage, which may or may not be possible, depending on your situation.

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