Make sure you understand the terms of an interest-only mortgage before you sign.
How interest-only mortgages work
When you take out a traditional mortgage, you pay the lender a monthly amount that’s a blend of principal plus interest. The principal goes to repayment of the money you borrowed. The interest is what the financial institution charges for the use of the money.
When you take out an interest-only mortgage, you pay only interest every month for a fixed period of time -- usually the first five to 10 years. Then, depending on the term of your mortgage loan, you have 20 to 25 years to repay all of the principal, plus interest. You can pay money toward the principal during the interest-only period, but make sure your interest is recalculated on the new balance.
An interest-only loan could be ideal for you if you want to keep your monthly payments low and are not concerned about falling home values. Refinancing with an interest-only mortgage is an idea you might want to consider if you are experiencing a temporary financial squeeze -- if, for instance, you or your spouse has chosen to go back to school, or one of you has decided to take a few years off with your children. Paying only interest for a few years could help you to stay in your current home, even though you can’t make your conventional mortgage payments for the time being. Of course, remember that you will only be paying interest during that time and not paying down the principal of the loan.
Your payments rise later
When you take out an interest-only mortgage, whether it’s for the purchase of a new home or to refinance your current home, you must bear in mind that when the five- or 10-year interest-only period expires, your payments will increase. In fact, they will be much higher than if you had taken out a conventional mortgage. This is because you must now pay off the principal in a much shorter period of time.
So before you opt for an interest-only mortgage, make sure that you will be able to afford the higher payments you will face in five to 10 years, or you will face refinancing -- possibly at a higher interest rate -- or selling your home.
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Pros |
Cons |
| More affordable during the first few years than a conventional mortgage that charges both interest and principal. |
Leaves you no better off when the interest-only period expires than if you had rented for five or 10 years. |
| May offer a lower initial monthly payment. |
Eventually requires you to repay the entire principal owing at an accelerated pace, with much higher monthly payments. |
| Allows you to spend the money you save in the first few years on other priorities. |
You could go upside-down on your mortgage loan, if the house declines in value during the interest-only period of your loan. |
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