Interest-only loans vs conventional loans: What you need to know
Quick insights
- Interest-only loans offer lower initial payments but do not build equity during the interest-only period.
- Conventional mortgage loans require higher monthly payments but help build equity and are more common among homebuyers.
- Interest-only loans may have stricter requirements compared to conventional loans, depending on the lender.
As a homebuyer, it's helpful to understand the home lending options available for your purchase. If you're looking for a loan option with lower initial monthly payments, an interest-only loan may be worth exploring. If you're looking for a more common mortgage option that helps you pay down principal over time, you may want to consider a conventional loan.
What is an interest-only loan?
An interest-only loan is a type of mortgage loan where you’re only making payments toward the interest for a set period of time. Interest is what your lender charges for borrowing the money for your mortgage. This means you aren’t paying back the principal — the money you’ve actually borrowed.
It’s key to note that interest-only loans keep your monthly payments down for a period of time, but don’t help build equity beyond the down payment you made on your home.
How does an interest-only loan work?
Interest-only loans provide short-term benefits for you, the borrower. The interest-only period usually lasts about five to 10 years. When your interest-only term ends, the principal amount you borrowed remains and payments towards it kick in. At this point, you may decide to move, refinance or apply for another interest-only loan.
You do, however, have the option to make additional payments towards your principal during the life of your interest-only loan.
What is a conventional loan?
Conventional loans are the most common type of mortgage for buying or refinancing a home. They’re backed by private lenders rather than government agencies.
Conventional loan monthly payments are higher than interest-only loan payments because they combine both the interest and principal amount every month. They can be set up as adjustable-rate mortgages or fixed-rate mortgages. An adjustable-rate mortgage has an interest rate that stays the same for an initial period of time, then varies once that period ends. A fixed-rate mortgage stays at one agreed upon interest rate throughout the life of your loan.
How do conventional loans work?
There are different types of conventional loans, but most carry a 15- or 30-year mortgage term. Conventional loans have more strict qualifications than FHA or other government-backed loans but are typically easier to qualify for than interest-only loans.
Qualifying for your loan
Interest-only loans are more competitive to qualify for than conventional loans because they’re considered a higher risk for the lender. There isn’t a standardized qualification across the board, but lenders tend to look for higher credit scores and lower debt-to-income ratios for interest-only loans than they usually do for conventional loans.
Which type of loan should I choose?
When choosing a loan, you should keep in mind both what you’re looking for and what you might qualify for. People who qualify usually get interest-only loans if:
- They plan to live somewhere for a short term.
- They want to keep their monthly payments down.
- They want a more expensive home.
Conventional loans make up the majority of sale and purchase real estate transactions. If you don’t qualify for an FHA loan or other government assistance programs, you’ll likely apply for a conventional loan.
As an educated homebuyer, you’re on the way to finding a mortgage option that fits your needs. Speak with your Home Lending Advisor today to find out about next steps. Happy house hunting!
