To put it simply, an interest-only mortgage is when you only pay interest the first several years of the loan — making your monthly payments lower when you first start making mortgage payments. Though this may sound like an exciting opportunity to help save on your mortgage payments, before exploring interest-only loan options, learning how they work is key.
An important thing to remember about interest-only mortgages is: Once the interest-only period ends, you begin paying both the interest and principal. You have the option of making principal payments during your interest-only payment term, but once the interest-only period ends, both interest and principal payments are required. Keep in mind that the amount of time you have for repaying the principal is shorter than your overall loan term.
How an interest-only works
Most interest-only loans are structured as an adjustable-rate mortgage (ARM) and the ability to make interest-only payments can last up to 10 years. After this introductory period, you’ll start to repay both principal and interest. The interest rate on an ARM Loan can increase or decrease throughout the length of your loan, so when your rate adjusts, your payment will change too.
For example, if you take out a $100,000 interest-only ARM at five percent, with an interest only period of 10 years, you’d have to pay about $417 per month (only towards the interest) for the first 10 years. When this interest-only period ends, your monthly payment amount will raise substantially with the inclusion of both principal and interest payments. Additionally, if the interest-only loan is also an ARM, the payment amount may also fluctuate due to the periodic interest rate changes.
Why get an interest-only mortgage
If you’re interested in keeping your month-to-month housing costs low, an interest-only loan may be a good option. Common candidates for an interest-only mortgage are people who aren’t looking to own a home for the long-term — they may be frequent movers or are purchasing the home as a short-term investment.
If you’re looking to buy a second home, you may want to consider an interest-only loan. Some people buy a second home and eventually turn it into their primary home. Making payments towards just the interest may be convenient if you aren’t permanently living in the home yet.
While an interest-only loan may sound appealing for people looking to keep their payments low, it can be more difficult to get approved and is typically more accessible for people with significant savings, high credit scores and a low debt-to-income ratio.
The pros of an interest-only loan
Interest-only loans may make financial sense for some borrowers because:
- The initial monthly payments are usually lower: Since you’re only making payments towards interest the first several years, your monthly payments are usually lower compared to some other loans.
- May help you afford a pricier home: You may be able to borrow a larger sum of money because of the lower interest-only payments during the introductory period.
- Can be paid off faster than a conventional loan: If you’re making extra payments towards an interest-only loan, the lower principal can generate a lower payment each month. When it comes to a conventional loan, extra payments can reduce the principal, but the monthly payments remain the same.
- Possible increase to your cash flow: Lower monthly payments can leave you with a few extra dollars in your budget.
- Rates may be lower: This type of mortgage is usually structured as an adjustable-rate loan, which may result in lower rates than a fixed mortgage.
The cons of an interest-only loan
Choosing an interest-only loan could be a risk for borrowers. Some cons with this type of loan include:
- You’re not building equity in the home: Building equity is important if you want your home to increase in value. With an interest-only loan, you aren’t building equity on your home until you begin making payments towards the principal.
- You can lose existing equity gained from your payment: If the value of your home declines, this may cancel out any equity you had from your down payment. Losing equity can make it difficult to refinance.
- Low payments are temporary: Low monthly payments for a short period of time may sound appealing, but they don’t last forever — it doesn’t eliminate the eventuality of paying back your full loan. Once the interest-only period ends, your payments will increase significantly.
- Interest rates can go up: Interest-only loans usually come with variable interest rates. If rates rise, so will the amount of interest you pay on your mortgage.
How can an interest-only mortgage calculator help?
You can use an interest-only mortgage calculator to help break down what your payments will look like the first few years with interest-only, and the consecutive years when principal rates kick in to see if this type of mortgage makes sense for you.
Learn more about interest-only mortgage options
An interest-only mortgage has its benefits and drawbacks. If you’re looking for lower monthly payments or a short-term living arrangement, this could be the right option for you. Keep in mind that payments towards your principal are inevitable down the line. Talk with a Home Lending Advisor to see if an interest-only mortgage is right for you.