Most mortgage payments are split into two when they get to the bank; a small portion reduces the equity, and the balance pays the interest. At least most home loans work this way. Some lenders have now introduced a new type of loan to attract more borrowers by keeping the monthly payment as low as possible by only paying the interest.
Basically the homeowner can pay what he wants, as long as he covers the minimum of the interest payment. Of course, most lenders will let you pay more than the minimum interest payment each time you want, but that is not the purpose of the loan, which is to keep the monthly payment as low as possible.
There may have been some rationale to this type of loan when property prices were increasing drastically, since the borrower would be guaranteed some equity because of the increased home price. It used to be that homeowners built equity by paying off some of the loan, and by the added value of the house.
Now that real estate values are falling rather than rising, the validity of interest only loans has been called into question. Interest only loans may have a value in some situations where you have to keep the monthly payment low. But it should really only be used as a temporary measure.
One example may be when a two income couple temporarily only has one income, for instance if one of them went back to school. This is a temporary situation, and when the second partner finishes his studies and starts a job, the loan should be changed to interest plus equity or additional payments should be made to reduce the loan.
Another case may be that of a wage earner with erratic income that changes from one month to the next. Such an example may be a project worker who is only paid upon the completion of the project. When income is low, the lower payment (interest only) option could be used and then when the windfall income was received, higher payments could be made to pay down the loan.
But in any of these cases, the homeowners cannot count on the price of the home rising and should make sure principal payments are made. You want to make sure that you pay down some of the principle so that you will have some equity built in the home, since you can no longer count on housing market increases to do so. However, if you always pick the interest only option, the loan principal will never be reduced, and the amount received by the sale of the home will not be enough to pay down the loan.
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