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The world of mortgages and homebuying can be confusing, especially because there are so many different options to consider. This simple guide breaks down what an interest-only mortgage is and when this type of mortgage might be better than a more traditional type of home loan.

Loan debt generally consists of two parts: the principal, or the total amount of the loan, and interest, or the extra amount the lender charges as compensation for what you've borrowed. When most people make mortgage payments every month, their payment amount includes the total calculated interest payment for that month plus a small portion of the principal. With an interest-only loan, though, your monthly bill only reflects the interest payment. This means your total monthly bills are lower than that of a person with a more traditional mortgage type. However, that doesn't mean you don't have to pay off the principal. Paying off the principal is the only way to build equity in a home. Failure to pay down the principal means you fail to reap the major benefits of home ownership. Interest-only mortgage is best for people who can afford to make occasional large principal payments rather than small monthly payments—this is not necessarily a financially advantageous option for people with limited income.

When Interest-Only Makes Sense

There are some situations in which interest-only home loans make sense. For example, if you work in a profession where your annual income is relatively high, but it tends to come to you in chunks through commissions or bonuses, an interest-only mortgage might be a good option. This style of mortgage can also be a suitable choice for people who only plan to stay in their home for a limited period of time, or who expect their financial situation to change in the relatively near future.

Strategizing Your Mortgage

It's a good idea to think strategically if you're considering an interest-only mortgage. For example, if you expect that interest rates will go down or that you'll otherwise be able to get better terms on a mortgage within 5-10 years, you can get an interest-only mortgage and plan to refinance. People who are buying a second home for vacation or rental purposes and eventually plan to live in it as a primary residence someday may want an interest-only mortgage and then use the proceeds of the sale of their first home to pay off the principal on the second.

Qualifying for Interest-Only Mortgages

Who can qualify for an interest-only mortgage? That depends. Most loan mortgage companies have their own specific requirements, but in general, this loan type is only available to those with high credit scores and significant assets. Lenders generally want to know that they'll be paid back for borrowed money, and since interest-only mortgages essentially let borrowers pay their principal on their own schedule, that's a bigger risk for the bank.

Making Smart Financial Decisions

There are some obvious points of appeal with an interest-only mortgage, including the fact that monthly payments can be low because you aren't paying down your principal. But it's important to be realistic. If you aren't paying down the principal, you aren't relieving yourself of debt, and that can be a risky way to use your money. Interest-only mortgages only make sense in certain contexts, so think carefully before you head down this particular finance path.