What Is an Interest-Only Mortgage and How Does It Work?
An interest-only mortgage (IO mortgage) is a home loan that allows you to make only interest payments for an initial period. Following that period, you can either refinance, pay the remaining balance in a lump sum or begin making regular monthly payments. The benefit of an interest-only mortgage is that you can achieve low monthly payments during the first several years you own the home — but there are many drawbacks, and interest-only mortgages are considered risky. Here’s everything you need to know about how they work and how you can qualify.
Understanding interest-only mortgages
Interest-only home loans require a smaller initial monthly payment that covers only the interest portion of the mortgage. Conventional loans, on the other hand, are amortized. Each monthly payment covers a portion of the principal and interest.
The appeal of an interest-only mortgage is the lower initial payment, which you can stick with for as long as ten years before making any payments towards the principal. But you’ll pay more in overall interest — plus, since interest-only loans aren’t qualified mortgages, there can be stricter requirements to qualify.
So, why would someone want to take out an interest-only mortgage? They might have another investment opportunity and want to free up cash, or perhaps they’re looking to sell or refinance after a short period of time or expecting to come into more money before the interest-only period ends.
In today’s market, it’s possible to buy a home with an interest-only mortgage, sell it before any principal payments are due and earn a profit, says Mayer Dallal, managing director at non-qualified mortgage lender MBANC. “The home prices are going up, so they can take advantage of the capital appreciation that way,” he says.
How do interest-only mortgages work?
There are two different periods that make up the borrowing term for an interest-only mortgage loan.
Interest-only mortgages don’t qualify for government-backed programs like FHA, VA or USDA loans. And there are a few other key differences between interest-only and conventional mortgages as well.
“The rates on interest-only loans, often called IO loans for short, tend to be a bit above conventional mortgages and the maximum loan to value ratios tend to be a little less than conventional loans,” says Doug Perry, strategic financing director at Real Estate Bees. Dallal concurs that “the larger big name banks have higher down payment requirements,” but notes that alternative lenders like MBANC typically will lend up to 85% of the value of the home. Still, borrowers would need more savings than they would for a government-backed mortgage.
You’ll also pay more interest overall than you would with a conventional mortgage, unless you make extra payments during the initial phase. Here’s an interest-only loan example of what you would pay each month if you took out an interest-only home loan instead of a conventional mortgage. Let’s assume you borrowed $200,000 with a 5% APR and a 10-year interest-only period.
|Initial Monthly Payment
|Amortized Monthly Payment
|Total Interest Paid
|10 Year Interest-Only Mortgage
|Conventional Mortgage (20% down payment)
Note that many interest-only mortgages are adjustable-rate mortgages, which have an APR that varies with the prime rate. So you may not have predictable fixed monthly payments with an interest-only home loan.
Qualifying for an interest-only mortgage
You may think that a mortgage with a lower initial down payment would be easier to qualify for on the same income, but that’s not necessarily the case. In fact, some lenders may have even more stringent requirements.
“As rates continue to creep up, as home prices continue to creep up, interest-only loans become more of an affordability option, but not as a crutch to qualify,” says Dallal, “because we still qualify the individual as if it was a 30-year payment.”
To qualify for an interest-only mortgage loan, you’ll likely need:
→ A good FICO score above 700
→ A low debt-to-income ratio below 36%
→ A down payment of at least 15% (depending on the lender)
→ Sufficient income and assets to repay the loan
That said, Perry notes that “interest-only loans can use a variety of means to demonstrate the ability to repay, ranging from using traditional paystubs to calculate income and alternative means, such as using bank statements to derive an income or to make the monthly payment.”
Interest-only loan pros and cons
Requires low initial monthly payment: With a conventional home loan, you’d make payments towards the interest and principal. Since an interest-only mortgage only requires interest payments during the initial phase, your monthly payment will be lower than a comparable conventional mortgage.
Frees up cash flow for other investments: With a lower monthly payment, you can invest more available income with the potential to grow your money faster. You also could have money stashed in a retirement account that will become available to you at the end of the interest-only payment period.
Allows you to reduce your monthly payment: “The loan recasts the minute you pay down your original balance,” says Dallal. So if you make extra payments during the interest-only period, you can lower your amortized payment. With a conventional fixed-rate mortgage, your monthly payment always stays the same.
Offers initial 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.
Interest-only payments don’t build equity: You won’t build equity in your home unless you make extra payments towards 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.
Refinancing is not guaranteed: If your home loses value, it could deplete the equity you had from your down payment — that could make refinancing a challenge.
Payments will increase down the road: “It is important to realize the IO loans will either convert to an amortized loan at some point, such as ten years after origination, or have a balloon payment due, so make sure you understand the loan terms if you are getting an interest-only loan,” says Perry.
You’ll pay more interest over the life of the loan: Though your initial payment will be smaller, your total interest paid will be higher than with a conventional mortgage.
Lenders may have more stringent requirements: There may be higher down payment requirements, and it may be more difficult to qualify for an interest-only mortgage with regards to your credit score. You’ll also need to demonstrate that you’d be able to repay the loan even when the monthly payment increases.
Should you borrow an interest-only mortgage?
You should consider an interest-only loan if…
→ You’re planning to live in the home for a short time: If you’re planning to sell before the interest-only period is up, an interest-only mortgage could make sense, especially if home values are appreciating in your area.
→ You’re planning to use the home as a rental or investment property: If you plan to fix and flip or rent the property as a long or short-term rental, you can lower your monthly expenses with an interest-only loan.
→ You can afford the payments but want more cash flow: If you can recoup the extra interest you’d pay on an interest-only mortgage with another investment opportunity, having the flexibility of lower payments could help you grow your money.
→ You’ll be coming into more money by amortization time: If you’ll have access to your retirement account, another investment or an inheritance by the time the interest-only period comes to an end, you might be able to buy more house with an interest-only loan.
You shouldn’t consider an interest-only loan if…
→ You can’t afford the full monthly payment: Eventually, you’ll have to make payments towards the principal and interest. Don’t assume you’ll be earning enough income at that time. Budget for repayment based on the income you earn today.
→ You need down payment assistance: If you can’t afford at least a 15% down payment, you’ll want to consider another type of home loan, such as an FHA loan.
→ You’re buying in an area where values are dropping: If home prices are depreciating, you’ll lose equity in your home and have difficulty with refinancing.
→ You want the most cost-effective mortgage: An interest-only loan is going to be more expensive to finance than a conventional mortgage. If your primary concern is spending the least over the life of the loan, choose another alternative.
Interest-only mortgage alternatives
If an interest-only loan isn’t a good fit, one alternative would be a hybrid adjustable-rate mortgage, says Perry. “It has a lower rate than a fixed rate loan but still has a fixed rate for the initial term such as seven or 10 years so it can provide a lower payment than a 30-year fixed rate fully amortized loan.”
A hybrid mortgage can offer a lower initial monthly payment, similar to an interest-only loan. The drawback is that once the interest rate converts to an adjustable rate, your payments can be unpredictable.
Conventional fixed-rate mortgage
If the idea of unpredictable payments causes you stress, or if you want to save money over the life of your home loan, a conventional fixed-rate mortgage is a good alternative. When you apply for a conventional fixed-rate mortgage, you’ll lock in your APR and your monthly payments will remain the same over the entire term.
Conventional fixed-rate mortgages typically come in 15- or 30-year terms. However, its main drawback is that rates tend to be higher than with adjustable rate mortgages.
If you don’t have enough saved for the down payment required for a conventional mortgage, or if you can’t qualify for a conventional mortgage based on your credit score, an FHA loan may be a good option.
Requirements for an FHA loan are much looser than those of a conventional loan. You can qualify with fair credit, a 3.5% down payment and a higher debt-to-income ratio. You can even use an FHA loan to finance a multi-family rental property or a fixer upper. However, keep in mind that you’ll need to pay mortgage insurance on an FHA loan, which can drive up your overall cost.