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An interest only mortgage is when the monthly payment due consists only of the interest on the loan. If the borrower pays only the amount due, the principal is never paid. Usually interest only loans are limited to a smaller number of years than a conventional mortgage. This is to protect not only the borrower, but the mortgage holder as well.
There are several circumstances under which an interest only mortgage makes sense. One would be where the borrower has a fluctuating income. The interest only mortgage would allow the borrower to have a smaller monthly commitment, but could pay down the principal when they have more money available due to a bonus or sales commission.
Another example would be someone buying a house for a rental property. Rather than wanting the property to be an investment, they may want to show a positive cash flow from rentals. They would therefore want a lower payment in the early years of the loan. Later, when the rents go up, they can refinance, or simply begin to pay against the principal.
A third scenario where the interest only loan would be attractive is when the buyer is flipping the house for a quick gain. In this case, the purchaser wants to minimize the initial investment to increase the profit when the property sells.
With the recent problems in the housing and mortgage industries, it has become more important to be aware of the risks involved in this type of loan. From the buyer's perspective, this loan makes sense under a limited number of circumstances. A buyer should never have to get talk into an interest only loan. On the other side, the lender needs to take steps to insure the borrower isn't trying to avoid paying the principal or paying for mortgage insurance.
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