An interest-only mortgage lets you pay just interest for a set period of time, typically between seven and 10 years, as opposed to paying interest plus principal from the beginning of the loan term.
While interest-only mortgages can mean lower payments for a while, they also mean you aren’t building up equity (ownership) in your home. Plus, you will likely have a big jump in payments when the interest-only period ends and you are repaying both interest and principal.
Read on to learn how interest-only mortgages work, their pros and cons, and who might consider getting one.
How Do Interest-Only Mortgages Work?
With an interest-only mortgage, you solely make interest payments for the first several years of the loan. During this time, your payments won’t reduce the principal and you won’t build equity in your home.
When the interest-only period ends, you generally have a few options: You can continue to pay off the loan, making higher payments that include interest and principal; look to refinance the loan (which can provide for new terms and potentially lower interest payments with the principal); or choose to sell the home (or use saved up cash) to fully pay off the loan.
Usually, interest-only loans are structured as a type of adjustable-rate mortgage (ARM). The interest rate is fixed at first then, after a specified number of years, the interest rate increases or decreases periodically based on market rates. ARMs usually have lower starting interest rates than fixed-rate loans, but their rates can be higher during the adjustable period. Fixed-rate interest-only mortgages are uncommon.
An interest-only mortgage typically starts out with a lower initial payment than other types of mortgages, and you can stick with those payments as long as 10 years before making any payments toward the principal. However, you typically end up paying more in overall interest than you would with a traditional mortgage.
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Interest-Only Loan Pros and Cons
Before you choose to take out an interest-only mortgage, it’s a good idea to carefully weigh both the benefits and drawbacks.
Pros
• Lower initial payments The initial monthly payments on interest-only loans tend to be significantly lower than payments on regular mortgages, since they don’t include any principal.
• Lower interest rate Because interest-only mortgages are usually structured as ARMs, initial rates are often lower than those for 30-year fixed-rate mortgages.
• Frees up cash flow With a lower monthly payment, you may be able to set aside some extra money for other goals and investments.
• Delays higher payments An interest-only mortgage allows you to defer large payments into future years when your income may be higher.
• Tax benefits Since you can deduct mortgage interest on your tax return, an interest-only mortgage could result in significant tax savings during the interest-only payment phase.
Cons
• Cost more overall Though your initial payments will be smaller, the total amount of interest you will pay over the life of the loan will likely be higher than with a principal-and-interest mortgage.
• Interest-only payments don’t build equity You won’t build equity in your home unless you make extra payments toward the principal during the interest-only period. That means you won’t be able to borrow against the equity in your home with a home equity loan or home equity line of credit.
• Payments will increase down the road When payments start to include principal, they will get significantly higher. Depending on market rates, the interest rate may also go up after the initial fixed-rate period.
• You can’t count on refinance If your home loses value, it could deplete the equity you had from your down payment, making refinancing a challenge.
• Strict qualification requirements Lenders often have higher down payment requirements and stricter qualification criteria for interest-only mortgages.
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Who Might Want an Interest-Only Loan?
You may want to consider an interest-only mortgage loan if:
• You want short-term cash flow A very low payment during the interest-only period could help free up cash. If you can use that cash for another investment opportunity, it might more than cover the added expense of this type of mortgage.
• You plan to own the home for a short time If you’re planning to sell before the interest-only period is up, an interest-only mortgage might make sense, especially if home values are appreciating in your area.
• You’re buying a retirement home If you’re nearing retirement, you might use an interest-only loan to buy a vacation home that will become your primary home after you stop working. When you sell off your first home, you can use the money to pay off the interest-only loan.
• You expect an income increase or windfall If you expect to have a significant bump up in income or access to a large lump sum by the time the interest period ends, you might be able to buy more house with an interest-only loan.
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Qualifying for an Interest-Only Loan
Interest-only loans aren’t qualified mortgages, which means they don’t meet the backing criteria for Fannie Mae, Freddie Mac, or the other government entities that insure mortgages. As a result, these loans pose more risk to a lender and, therefore, can be more difficult to qualify for.
In general, you may need the following to get approved for an interest-only loan:
• A minimum credit score of 700 or higher
• A debt-to-income (DTI) ratio of 43% or lower
• A down payment of at least 20% to 30% percent
• Sufficient income and assets to repay the loan
The Takeaway
An interest-only mortgage generally isn’t ideal for most home-buyers, including first-time home-buyers. However, this type of mortgage can be a useful tool for some borrowers with strong credit who fully understand the risks involved and are looking at short-term ownership or have a plan for how they will cover the step-up in payment amounts that will come down the road.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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