What Are Interest-Only Mortgages? And How Do They Work?

Written by Elijah BishopUpdated: 15th Mar 2022
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An interest-only mortgage allows you to pay only the mortgage’sborrowing charges, known as interest. That implies you won’t be repaying any of your loan’s principal (the amount borrowed) for the first few years. While this may appear to be a convenient method to ease into homeownership, interest-only mortgages can be difficult to get and come with several disadvantages.

Below, we’ll discuss what an interest-only mortgage is, how to qualify for one, and some of the pros and cons so you can make the right choice.

What Is an Interest-Only Mortgage? 

An interest-only mortgage is a mortgage loan that initially requires you to pay just the interest payments and not the principal. That is, your early payments will not reduce your main mortgage balance. Interest-only mortgages have lower monthly payments initially. However, payments become significantly more expensive later on.

Your interest-only term will finish after a set amount of time, commonly between three and ten years. Your loan installments are then recalculated, and you will begin paying both principal and interest. As a result, your monthly payment will be increased for the remainder of the loan period.

>> More: See the Best Mortgage Lenders

How Do Interest-Only Mortgages Work? 

Interest-only mortgages can be fixed-rate or adjustable-rate loans. Your interest rate will never fluctuate with a fixed-rate loan. An adjustable-rate loan is linked to a financial index. That implies your rate may fluctuate over time.

Your loan will have a specified repayment period, such as 30 years. As previously stated, you will only pay interest for the first several years. Then you’ll have to pay principal plus interest, which will increase your monthly payment.

Because your loan balance did not decrease during the interest-only term, you will have a shorter time to pay it off, and your payments will be greater. Assume you pay only interest for the first ten years of a 30-year fixed-rate loan. You will pay down your principal sum for the final 20 years of your loan. Your payments will be greater since you would have 20 years instead of 30 years to pay off the entire sum. You may use a mortgage calculator to play with the numbers and see your payments.

>> More: How to Get Preapproved for a Mortgage

Types of Interest-Only Mortgages

Adjustable-Rate Interest-Only Mortgage Loan 

Most interest-only loans are structured as adjustable-rate mortgages (ARMs). An interest-only loan can be structured as a 3/1, 5/1, 7/1, or 10/1, with the top number (3, 5, 7, 10) indicating the number of years you’d pay interest only.

The bottom number (the “1”) represents the number of times the mortgage rate is modified each year. This means that your loan’s interest rate changes once a year (and only once a year) based on current rates. Banks frequently use LIBOR benchmarks to determine interest rates (and SOFR after 2021). But don’t be put off by the thought of an ARM. All ARMs have rate limitations, which means your interest rate will never surpass a specific percentage.

Fixed-Rate Interest-Only Mortgage

Fixed-rateinterest-only mortgages are extremely uncommon, although they do exist. With current interest rates so low, a fixed-rate mortgage nearly always makes better financial sense since you can lock in the low rate for the duration of your mortgage. Rates are unlikely to be lower than they are currently in our lifetime, which explains why there are many mortgages and refinance activities despite the current economic instability.

Who Can Qualify for an Interest-Only Mortgage?

Interest-only loans necessitate a higher credit score, a higher income, and a larger down payment. Additional requirements may include:

  • Assets.
  • Cash reserves (six to twelve months’ worth of mortgage payments in the bank).
  • A reduced debt-to-income ratio.

Even if you only pay the interest portion of the loan at first, your lender will most likely calculate your debt-to-income (DTI) ratiousing the principal and interest payment amount. The requirements will vary greatly depending on the lender, but plan to put down a significant down payment of 20% or more and have excellent credit (a score of 720 or higher).

Pros and Cons of Interest-Only Mortgages

Under certain conditions, interest-only loans can be a wise personal finance plan, but they are not for everyone. Here are some advantages and disadvantages:

Pros:

  • Leverage your savings: With no principal payment for several years, you can put that money toward another investment that may perform better in a shorter period. But, on the other hand, it’s a calculated risk.
  • Payment flexibility: If you receive a significant bonus, commission, or stock award, you can use the extra cash to pay down some of the principal, easing the larger monthly payments later. Principal payments are not needed but are permitted. Check your loan terms to ensure no limits or penalties for paying off the principal early.
  • Less stringent qualification standards: Because these loans are not sold to Fannie or Freddie, lenders have more freedom to set their requirements for borrowers. That doesn’t imply you won’t get a loan if you have a low income and bad credit. On the other hand, Lenders have more leeway in determining who to lend to and how much they’re ready to lend.

Cons:

  • Substantially higher payments later: Your monthly payment will rise when the interest-only period ends since you must begin repaying the principal. If you have an adjustable-rate loan, your interest rate may rise as well, depending on the market rate at the time, which can raise your monthly payment even more.
  • Longer-term costs if you don’t sell or refinance: When compared to a 30-year fixed-rate mortgage or ARM, an interest-only mortgage for 30 years will normally end up costing you more because the principal payments are pushed off in the early years of the loan term.
  • There’s no assurance you’ll be able to get out of it: You might not be able to sell or refinance when you want to get out of your interest-only loan. There are unknown market risks, such as a decrease in the value of your house, your income not being sufficient for a refinance at the time, or an increase in interest rates.
  • More difficult to get: Interest-only mortgages are a specialized product that not all lenders offer.

Who Should Use an Interest-Only Mortgage Loan? 

If you have one or more of the following traits, you might benefit from an interest-only mortgage:

  • If you do not intend to keep the mortgage for a time longer than the interest-only period.
  • If you are buying out another person’s ownership of a home and require minimum monthly payments until you can sell it.
  • If you need temporary finance for a new house while you try to sell your old one (an alternative to a bridge loan).
  • If you’re not as concerned about accumulating home equity.
  • If you’re getting a jumbo loan because the savings from merely paying interest on a small loan are insignificant.

Can You Get an Interest-Only Loan? 

Nonqualified mortgages are interest-only loans. This implies that Fannie Mae and Freddie Mac, the government-sponsored enterprises that buy most mortgages from lenders to facilitate credit flow to homebuyers, do not acquire or support interest-only mortgages. 

Interest-only mortgages are more difficult to obtain because they contributed to the 2008 financial crisis by homeowners unable to afford the increase in mortgage payments when the loan was amortized and home prices were underwater. Lenders who still offer interest-only mortgages tend to keep them in their portfolios or sell them to certain investors willing to take on such risks.

>> More: Understanding Government Home Loans

Where Can You Get an Interest-Only Mortgage? 

Finding a lender willing to underwrite an interest-only loan is easier said than done. If you have a high monthly income, good credit, and a substantial cash reserve, your primary financial institution is the best location to begin your search. If you decide to look into possibilities other than where you conduct your daily banking, make sure you only deal with reliable lenders. Before disclosing any personal information, check the lender’s rating with the Better Business Bureau and read any internet reviews.

Check with your real estate agent or the lender or mortgage broker that assisted with financing any past home purchases to see if they can recommend any lenders offering interest-only mortgages.

Why Do Lenders Prefer Conforming Loans? 

A conforming loan is a mortgage loan that meets the requirements of Fannie Mae and Freddie Mac. Only conventional loans (loans not backed by any government agency) are conforming loans.

The distinction between conforming and non-conforming loans is crucial for economic reasons. Once a mortgage lender has funded your loan, it is often sold to Freddie Mac, Fannie Mae, or other government-sponsored enterprises.

These businesses purchase mortgages to assist the funding financial institution’s liquidity. This assists lenders in getting mortgages “off the books,” allowing them to fund more mortgages.

Are Nonconforming Loans Predatory? 

The simple answer is no. Nonconforming loans come in various forms, including VA, FHA, and jumbo mortgages, to mention a few. Many borrowers can only qualify for an FHA or jumbo mortgage; therefore, these aren’t inherently exploitative when offered by a trustworthy lender. Nonconforming loans might be unfavorable because they do not have lending limitations, whereas conforming loans do.

Bottom Line: Interest-Only Mortgages

An interest-only mortgage offers advantages and disadvantages. If you want cheaper monthly expenses or a short-term living arrangement, this could be the correct choice for you. Remember that payments for your principal are unavoidable in the long run. Consult with a Home Lending Advisor to determine whether an interest-only mortgage is appropriate for you.

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a Bachelors of Arts Degree in Creative writing from Georgia State University and has also attended the Climer School of Real Estate. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.