What Is An Interest-Only Mortgage?
Usually, when you make a mortgage payment, part of it reduces the principal and the rest pays the interest. An interest-only loan lets you pay for only the interest for a specific number of years, after which you have to pay both principal and interest. This reduces your monthly payment for the first few years of repayment. However, your payment will increase when you start paying principal in addition to interest. Here’s what you need to know about interest-only mortgages and their pros and cons.
Key Takeaways:
- An interest-only loan allows you to pay only the interest on your loan for the first three to 10 years.
- You will build equity at a slower rate with an interest-only loan and will pay more interest overall.
- Interest-only loans can be helpful if you don’t plan to own the home until you have to pay principal.
How Do Interest-Only Mortgages Work?
An interest-only mortgage allows you to pay only the interest for a time, typically three to 10 years. This reduces your monthly payment, but your principal remains unchanged. When you start paying both interest and principal, your payment will increase significantly as you have less time to pay down the principal to zero.
Most interest-only loans are adjustable-rate mortgages. With an ARM, you pay a fixed introductory interest rate that typically is lower than the initial rate on a fixed-rate loan. The introductory rate can last up to 10 years. After it expires, your interest rate will adjust up or down according to market rates, usually once a year.
Interest-Only Mortgage Examples
Let’s say you take out a 30-year mortgage for $400,000 with a 6% interest rate and a seven-year interest-only period. During those first seven years, your mortgage payment would be $2,000. After seven years, you’ll have paid $168,000 in interest, and your principal balance still will be $400,000. Your monthly payment would then increase to $2,675 to pay off the principal with interest over the remaining 23 years of your loan term. Your interest rate will adjust, affecting your monthly payment and how much interest you pay. But if the 6% rate holds, you will pay a total of $506,407 in interest.
With a standard ARM, your monthly payment would be $2,398 because you pay both interest and principal. That’s higher than the introductory period on the interest-only loan and lower than the payment for principal and interest. Again, your monthly payment and total interest will change as the rate adjusts, but if your rate were to remain at 6%, you would pay $463,353 in interest.
That means you’ll pay $43,054 more for the interest-only loan, with the trade-off being the lower payment for the first seven years.
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Should You Consider An Interest-Only Mortgage?
An interest-only loan can make sense if you expect your income to increase but need to keep your short-term housing costs low. It also can be a helpful option if you expect to sell the home before the principal is due and don’t need to worry about higher monthly payments. Other times, buyers use an interest-only mortgage to buy a second home.
“For a homeowner who plans to hold property for less than seven years, an interest-only loan can help reduce the mortgage payment and offer more cash flow for other budgeted items,” says Neil Christiansen, a Certified Mortgage Advisor and Branch Manager at Churchill Mortgage in Arvada, Colorado. “Also, an interest-only could be a consideration for an investment property. Due to a lower monthly payment, the investor might utilize this loan product to increase their return on investment.”
If you plan to own the home longer than the interest-only period, you will need to afford the monthly payment when it increases. You’ll also need to understand that not paying down the principal means the only way you can build equity is if your home increases in value. If your home doesn’t increase in value, you’ll have no equity, which may make it difficult to sell or refinance your home.
How To Qualify For An Interest-Only Mortgage
Interest-only mortgages typically have stricter eligibility requirements than standard ARMs. Lenders usually require a higher credit score, a low debt-to-income ratio and significant savings for a down payment. While the exact criteria vary by lender, you can expect to need:
- A credit score of at least 700
- A down payment of at least 20%
- A DTI ratio of 36% or less
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Pros And Cons Of Interest-Only Mortgages
Before you commit to an interest-only mortgage, learn the benefits, downsides and risks.
Pros
Advantages of interest-only mortgages include:
- Pay a lower interest rate and make a smaller monthly payment during the interest-only period.
- Pay lower interest rates than a fixed-rate mortgage – at least at first.
- You have more room in your budget for other expenses.
- Lower initial payments may help you afford a more expensive house.
- You can pay it off faster than a conventional loan with extra principal payments.
- It can be a helpful mortgage for an investment property you plan to rent out.
Cons
Interest-only loans aren’t suitable for everyone. Here are some disadvantages:
- Your monthly mortgage payments will eventually increase.
- There are stricter eligibility requirements.
- Not paying down your principal means you can only build equity if your home increases in value.
- You’ll owe the lender the same principal amount years into the mortgage.
- If the value of your home decreases, you could end up with negative equity.
- You might be unable to sell or refinance before the end of the interest-only period.
- If you sell the home before the end of the introductory period, you will make no money on the deal unless the home has substantially increased in value.
- Your loan might require a balloon payment.
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Alternatives To An Interest-Only Mortgage
If an interest-only mortgage doesn’t sound right for you, here are some other options:
- Conforming conventional loans. This is the most common loan type in the United States. It has a maximum loan amount and typically costs less than a Federal Housing Administration loan but has stricter eligibility requirements.
- FHA loans. FHA mortgages can be cheaper for borrowers with a lower credit score and a smaller down payment.
- Veterans Affairs loans. No down payment is required, but VA loans are available only to eligible military service members, veterans, and their surviving spouses.
- U.S. Department of Agriculture loans. Aimed at low-to-moderate-income borrowers looking to buy a home in specific rural areas. No down payment is required for USDA loans.
- Jumbo loans. These loans exceed the limits for conforming loans and typically have stricter eligibility requirements. They are also known as nonconforming conventional loans.
- Balloon loans. These loans reduce the monthly payment and require a large final payment. These loans also have shorter terms – typically five to seven years.
FAQ
Here are answers to common questions about interest-only mortgages.
The Bottom Line
Interest-only mortgages can be helpful for borrowers who expect their income to increase. If you can benefit from lower monthly payments for the first few years of your mortgage but know you’ll be able to afford larger payments down the line, an interest-only loan may very well be of interest. Just beware that you won’t build equity during the interest-only period, and your monthly payment will ultimately increase significantly.
