Interest-Only Mortgages: What You Need to Know
If you’re looking to buy a home with the smallest monthly payment possible, you may have considered an interest-only mortgage. This type of mortgage allows you to pay the interest portion of your monthly payment, whereas a traditional mortgage payment covers both interest and principal owed on a home loan.
Though an interest-only mortgage may seem risky, there are unique situations where this product could be helpful. For some, it’s a way to afford a more expensive home for less. For others, say with certain financial goals or irregular income, an interest-only mortgage could be a useful cash management tool.
There are many terms and conditions attached to interest-only mortgages. Not only can your monthly payment amount change, but the interest-only mortgage rates can also change substantially over the life of the loan, so make sure you understand exactly what you’re getting into before signing on the dotted line.
Once you know more about interest-only mortgages, you’ll be in a better position to decide if this product is for you.
Overview of interest-only mortgages
An interest-only mortgage is a bit of a misnomer. It’s not actually a type of mortgage on its own, but rather an option that can be exercised with either a fixed-rate or adjustable-rate mortgage (ARM) product. Most people, however, are more familiar with the ARM version of interest-only mortgages.
The initial monthly payments for an interest-only mortgage will cover only the interest portion of your home loan, while the traditional mortgage covers both principal and interest. For interest-only loans, you can’t pay just interest forever — the term typically lasts for three to 10 years.
After the interest-only payment term is over, the loan payments become fully amortized, covering principal and interest, over the remainder of the loan. The amount of the adjustment will depend on a few factors such as the years left to pay, prevailing interest rates and the type (fixed rate versus adjustable rate) of loan you have.
How interest-only mortgages work
As mentioned above, there are two types of mortgages where you’ll have the interest-only option: an adjustable-rate mortgage (ARM) or fixed-rate mortgage. If you’re shopping for a mortgage, you may want to evaluate both options if your lender offers them.
The terms for these mortgages are expressed with two numbers with a slash in between — for example, 10/20 or 15/15. The first number is the amount of time in your initial terms of the loan (in this case the interest only) and the second number gives you some information about the second part of the term — like the length of the term or how often the interest rate adjusts.
Fixed-rate interest-only mortgage
With a fixed-rate interest-only mortgage, you can make interest-only payments for the initial term, normally up to 10 years. At the end of the interest-only term, the loan is amortized to include principal and interest. This means payments will increase.
When your initial interest-only rate is up, you could have some options aside from keeping the loan with the now higher payment. You could either sell your home to pay off the balance of the loan or refinance into a mortgage with a lower rate.
Possible terms for fixed-rate interest-only mortgages are:
- 10/20 fixed-rate interest only mortgage — 30-year loan, with 10 years of interest-only payments and 20 years of fully amortizing (principal + interest) payments
- 15/15 fixed-rate interest only mortgage — 30-year loan, with 15 years of interest-only payments and 15 years of fully amortizing (principal + interest) payments
For example, let’s say you purchase a home for $170,000 with a 30-year mortgage. You decide to exercise the option to pay interest only for the first 10 years, with fully-amortized payments for the remaining 20 years. The interest rate on this loan is 6.625%.
Here’s what your repayment schedule would look like based on this loan arrangement:
|Mortgage Repayment Schedule|
|Conventional; 30 year||10/20 Interest Only; 30 year|
|Monthly payment first 10 years||$1,089||$939|
|Monthly payment after 10 years||$1,089||$1,280|
|Balance owed after 10 years||$144,568||$170,000|
|Interest paid over 10 years||$105,192||$112,680|
Note: This example does not include a down payment, the cost of taxes or insurance.
When the 10 years come to an end, the new, fully-amortized, monthly payment will be higher because the $170,000 balance, which includes principal and interest, must now be paid over 20 years, not 30 years, like a traditional loan.
Adjustable-rate interest-only mortgage
An adjustable rate mortgage is a loan product that can also carry an interest-only option. An interest-only ARM has an initial period with a fixed rate and then goes on to adjust periodically. The frequency of adjustment is based on the terms you agree to.
As with a fixed rate, interest-only mortgage, you could also choose to sell or refinance your mortgage if you are not comfortable with monthly payments once the interest-only term is over or when the loan resets.
You should also know that an interest-only ARM is different from a fully-amortizing ARM. A fully-amortizing or traditional payment ARM has a monthly payment that is calculated to pay off the balance of the mortgage at the end of the loan term, whereas an interest-only ARM covers interest and escrow only for the initial, interest-only term.
Terms for interest-only adjustable-rate mortgages could be:
- 3/1-Fixed interest rate for 3 years, then adjusts annually
- 5/1- Fixed interest rate for 5 years, then adjusts annually
- 7/1- Fixed interest rate for 7 years, then adjusts annually
An example of a 5/1 interest-only ARM could offer a fixed interest rate for the first five years with interest-only payments for the first 10 years of the loan. Though the payments are interest-only for the first 10 years, after five years, the rate will adjust each year.
Both interest only and fully-amortizing ARMs have interest rate caps that control how the interest rate adjusts:
- Periodic caps — Limit the interest rate increase from one adjustment period to the next
- Overall caps — Limit interest rate increases over the life of a loan
As you can see, there are more than a few changes you’ll encounter with this type of interest-only loan. Your monthly payment could change many times throughout the loan. It’s a good idea to ask your lender to calculate the maximum monthly payment possible on the loan to give you an idea of what you are getting into.
When do interest-only mortgages make sense?
Though an interest-only loan can seem attractive because it comes with a lower initial loan payment, it could be dangerous for borrowers who don’t fully weigh the pros and cons associated with this type of mortgage.
The main risk here is not being able to cover potentially higher mortgage payments if the interest rate resets at a higher rate after the introductory period. Additionally, without building any equity in your home due to only paying interest, the equity in your home could decrease if the market value of your home decreases — making an exit strategy like a sale or loan refinance difficult.
However, there are definitely some scenarios when an interest-only mortgage makes sense:
- You’d like a lower monthly payment for a nicer, larger home, AND —
- Your income will increase to cover higher monthly payments in the future, AND —
- You will sell or refinance your home when the principal and interest payments kick in and/or the loan is recalculated.
Perhaps one of the most practical uses of this type of loan is for people with varying income — perhaps a seasonal worker or someone with an irregular business income. By exercising the interest-only option on the loan, you could get a lower payment you know you can handle, then pay more to build equity when your income increases.
Casey Fleming, mortgage adviser and author of “The Loan Guide: How to Get the Best Possible Mortgage,” says that a good example of using interest-only loans would be when, “Your base salary is a little tight each month but you expect windfall income (bonuses, stock options, inheritance, etc.) that you can use to pay down principal balance when it comes in.”
So an interest-only loan, along with the more flexible repayment options, can certainly make sense in some situations. You just have to be comfortable with the trade-offs of the convenience interest-only loans provide.
Fleming added, “There is a small premium to be paid in terms of upfront costs or the interest rate for the interest-only feature,” referring to refinance costs (if applicable,) discount points and interest rates that could reset at higher rates down the line.
Unless you’re getting a no-cost refinance loan, you could be on the hook for refinance closing costs like origination fees, settlement services, interest prepayments and escrow payments. With this in mind, you should think twice before refinancing into an interest-only mortgage.
Who’s eligible for an interest-only mortgage?
Interest-only loans require a higher credit score, income, and down payment. There may also be additional requirements around assets, liquidity (like six to 12 mortgage payments in the bank) and lower debt-to-income ratio.
Also, the bank will calculate a borrower’s debt-to-income ratio using the principal and interest payment amount even though he or she will only pay the interest portion on the loan in the beginning.
Though requirements will vary by lending institution, here’s an example of requirements for an ARM interest-only loan:
- Minimum credit score 720-740
- Down payment of at least 20%
- Debt to income ratio (DTI) 43%
- Able to make higher payments if loan resets at a higher interest rate
Jennifer Beeston, VP Mortgage Lending at guaranteedRate, confirms that these requirements are pretty industry- standard, but some banks may have products with more lenient or stricter guidelines.
Beeston says, “For example, we have a jumbo interest-only product that is a 30-year fixed with 10% down and no monthly mortgage insurance. Yes, the rate is higher than a normal 30 year fixed, but it does exist.”
Michelle Paxton, Sr. Mortgage Loan Officer at Guild Mortgage, agrees with the variability in requirements, “Interest-only loans could be approved with a 680 FICO, but DTI would be 43% for industry-standard, though I’ve seen it go higher.”
Pros and cons of interest-only loans
|Lower monthly payments to begin with, meaning additional cash available for other expenses||Payment can increase once the initial interest-only payment period is over|
|Could be ideal for someone with fluctuating income||Larger down payment may be required|
|You may qualify for a lower initial interest rate||You may not be able to cover a higher payment|
|You’re able to potentially afford “more” home for less money||You may not be able to sell or refinance your home|
|You can pay back the mortgage on a more “flexible schedule”||You will take longer to pay down the principal and you’ll pay far more in interest charges as a result|
|You will not build equity in your property right away|
Is an interest-only mortgage right for you?
An interest-only loan can work for certain type of borrowers. If your goal is to get a larger, nicer home with a smaller payment, this might not be the best move — unless you are sure you can cover larger payments down the line. If you can’t cover the principal and interest payment, refinance or sell your home when the payments increase, it could cause you financial strain.
Interest-only loans can be a tool to help you manage cash flow with lower payments. It can also be ideal if you will live in a home that you will not keep for very long but don’t want the “hassle” of a larger house payment.
If used properly, an interest-only loan could be helpful for qualified borrowers. Do your research and get the full picture of how and when your monthly payment could change. Shop around for the best interest-only mortgage rates and a loan arrangement that suits your needs.