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What Is an Interest-Only Mortgage and How Does It Work?

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An interest-only mortgage allows you to make payments only on the borrowing costs of a mortgage, known as interest. That means you’re not paying back any of the principal (the amount you borrowed) for the first few years of your loan.

Once the interest-only period ends, your loan will amortize and include both interest and principal payments until the loan is repaid in full. While this may sound like a helpful way to ease into homeownership, interest-only mortgages can be hard to find and come with several risks.

What is an interest-only mortgage?

With an interest-only mortgage, you pay interest only for a specified period — usually three to 10 years. After that period ends, the loan amortizes, and you make payments toward both interest and principal for the rest of the loan term.

Unlike a loan that’s fully amortized from the start, an interest-only mortgage can help keep your housing payments low in the initial years of homeownership. On the other hand, you won’t be paying down any of your principal loan balance or building equity in your home.

How do interest-only mortgages work?

An interest-only mortgage isn’t a standalone mortgage product, but rather a type of payment option offered in very limited circumstances. Interest-only payments may be combined with adjustable-rate mortgages (ARMs), as well as fixed-rate loans and jumbo mortgages.

Interest-only mortgage loans aren’t as common today as they were prior to the Great Recession. They’re considered highly risky — especially when tacked onto an ARM, which has variable interest rates that can make it harder to budget for a jump in payments when interest rates go up. As a result, you may not be able to afford your mortgage payments.

It is still possible to find interest-only mortgage lenders by searching online for alternative mortgage companies that offer non-qualified (non-QM) mortgage loans. These are loans that don’t meet more stringent federal guidelines to be considered a “qualified mortgage.” Interest-only loans tend to have higher delinquency rates than qualified mortgages.

Interest-only mortgage example

To illustrate how an interest-only home loan works, let’s say you take out a $200,000, 30-year, fixed-rate mortgage with five years of interest-only payments at 5%. We’ll compare that to a traditional mortgage, in which you make monthly payments of principal and interest for the entire loan term.

5/25 Interest-Only Mortgage Traditional 30-year Mortgage
Initial Loan Amount $200,000 $200,000
Interest Rate 5% 5%
Monthly Payment, First 5 Years $833 $1,074
Monthly Payment, Next 25 Years $1,169 $1,074
Total Interest Paid  $200,754 $186,512

By choosing an interest-only payment plan for the first five years of the loan, your monthly payment would be $241 lower for the first five years. However, it would cost you $14,242 in extra interest over the 30-year term, because you’re not chipping away at the principal balance for the first five years.

The good news is you can pay more than just the interest during that interest-only period. So if you chose an interest-only home loan because you needed a lower monthly payment, but you get a raise or a cash windfall later on, you can bump up your payment. That’ll help you pay down your loan balance before your interest-only period is up. However, you should first make sure that your lender doesn’t charge any prepayment penalties to do this.

Interest-only mortgage rates

While interest-only mortgage rates may initially be lower than fixed-rate loan interest rates, or even fully amortizing adjustable-rate mortgages, the loans are risky. You may not be able to afford the payments after the interest-only period expires, or if the adjustable rate rises during the interest-only period.

When interest rates are low, these loans might seem like a way to get a pricier home than you might otherwise be able to afford, but a lot can happen during that interest-only period. Your income could go down and mortgage rates could rise. This could leave you unable to make your mortgage payments and cause you to lose your home.

Who’s eligible for an interest-only home loan?

Interest-only loans require a higher credit score, income and down payment. There may also be additional requirements around assets, cash reserves (having six to 12 months’ of mortgage payments in the bank) and a lower debt-to-income ratio.

Your lender will likely determine your debt-to-income (DTI) ratio using the principal and interest payment amount, even though you’ll initially pay just the interest portion of the loan.

Requirements will vary drastically by lender, but expect to put down a large down payment of 20% or more and strong credit (a score of 720 or higher).

Pros and cons of an interest-only loan

Pros Cons
You’ll have lower monthly payments early on, which can free up cash for other expenses. Your monthly payment may increase once the interest-only period ends.
You could potentially afford a more expensive home with a lower monthly payment. You’ll take longer to build equity in your home, and you’ll pay more in interest over the loan term.
You may be able to sell or refinance your mortgage once the interest-only term ends. You may not be able to refinance or sell your home if home values drop.

Who should consider an interest-only mortgage

  • Buyers who expect to have a higher income in the future to cover larger monthly payments
  • Buyers of short-term investment properties who intend to “flip” the house for a profit before the interest-only period ends
  • Buyers with a fluctuating income who want the flexibility of making interest-only payments during leaner months and paying more when their income is higher

Who shouldn’t consider an interest-only mortgage

  • Buyers who want a more expensive home than they can reasonably afford using a traditional mortgage
  • Buyers of homes in neighborhoods where home values are falling
  • Buyers who cannot afford to cover a higher payment if interest rates rise just as their interest-only period expires

Another offering: Interest-only HELOCs

A home equity line of credit (HELOC) can be another interest-only loan product. While some HELOCs require borrowers to start paying interest and principal right away, an interest-only HELOC allows the borrower to pay interest only on the amount of money they withdraw during the initial years they have the line of credit open, known as the draw period.

When the draw period ends, however, the borrower must then make payments of interest and principal. For example, an interest-only HELOC may have a 10-year draw period in which the borrower makes interest-only payments. That’s followed by a 15-year repayment period in which they pay principal and interest until the balance is paid in full.

Most HELOCs are variable-rate loans, so they also come with a risk that interest rates will rise. As a result, you could wind up with a monthly payment that’s unaffordable.

 

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