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Interest-Only Mortgages: The Facts And Alternatives

5-Minute Read
Published on October 8, 2020

There are many methods used to try to make a home more affordable, including eliminating or reducing the down payment. Another way is to lower the monthly payment by getting a really good rate.

There are also interest-only mortgages, which save people money on their monthly payment for a period of time. Although Rocket Mortgage® doesn’t offer interest-only mortgages, we’ll explain what they are, their advantages and disadvantages and the alternatives.

What Is An Interest-Only Mortgage?

Interest-only mortgages have their advantages and disadvantages, but before we go any further, let’s start with the basics.

An interest-only mortgage is a payment option in which you pay only the interest for a number of years – usually either 5 or 10 – at the beginning of the loan term. During this period, your principal balance remains the same, and you aren’t required to pay any of it back. You can still make principal payments during this period if you want to, and it can be a good way to get ahead.

Once the initial time frame rounds out, your loan is reamortized (a fancy word that refers to payment recalculation) to include both principal and interest and have it all paid off by the end of the loan term. In this way, an interest-only loan can help keep your housing payments low during the first few years of home ownership.

The downside to this approach is that your home won’t accrue any equity, making it that much more difficult to secure a home equity line of credit (HELOC) should you choose to do so in the future.

Interest-only loans are structured as a ratio, such as 7/1 or 10/1. For example, a 10/1 loan means that your interest-only period will last 10 years, after which the rate adjusts once per year.

The amount that the rate will change is limited by rate caps, just like any adjustable-rate loan. The cap depends on the loan: 

  • 2% for 3/1 and 5/1 loans
  • 5% on 7/1 and 10/1 loans

Fixed Interest-Only Mortgage

Fixed interest-only mortgages are less common. With these loans, you still have the introductory interest-only period, but after that the interest rate does not adjust. This means that, over the life of the loan, you will typically pay less than you would with an adjustable interest-only loan because your rate is fixed. Additionally, you don’t have the same once-per-year adjustment.   

Advantages Of Interest-Only Mortgages

There are several reasons people consider interest-only loans. For instance, it might make good financial sense for you, depending on your long-term plans. On a traditional 30-year fixed rate loan, roughly two-thirds of the payment goes toward interest during the first 6 or 7 years of the loan. If your interest-only mortgage rate is low, then you’ve borrowed money at a good rate.

Instead of paying down that low-rate mortgage, the extra money each month from making interest-only payments can be invested in something that would yield a higher rate of return. Depending on the loan amount, you could have access to thousands of extra dollars over the course of several years that could be used for investments or reducing high-interest credit card debt.

It may also be the case that you only ever end up paying the interest. Today, Americans stay in their home for an average of 13 years. An interest-only mortgage is sometimes considered an option for people who expect to be in their homes for less than the term of the interest-only period. Many homeowners like the option of making interest-only payments and using the extra money to save for college tuition, make home improvements, buy a much-needed new car, and so on.

Lastly, because mortgage interest is fully tax-deductible for those with loan balances of less than $750,000 (up to $1 million if you bought your home before December 16, 2017), there is a good chance that your entire monthly mortgage payment is deductible if you’re only paying interest.

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Disadvantages Of Interest-Only Mortgages

For all of their advantages, interest-only loans can also have significant drawbacks, including: 

  • They’re only offered under limited circumstances and are considered to be more risky than your standard loan. 
  • If you only make interest payments, when your mortgage resets and you start making principal and interest payments, you’re paying the full principal amount. Your interest payment may also go up, since you haven’t paid down any of the principal amount during the first several years. 
  • The adjustable rate could go up or your income could decline during the interest-only period – or both – putting you in a difficult situation. 

Generally speaking, interest-only mortgages are far less common these days than they were during the Great Recession of 2008. In fact, it was interest-only loans were part of what caused so much trouble leading up to the housing bubble burst. Today, few lenders will offer an interest-only loan. Because of this, you’re not likely to find an interest-only loan being offered by government-sponsored lenders like Fannie Mae and Freddie Mac.

If you’re looking for a lower monthly payment, one alternative you might want to take a look at is an adjustable rate mortgage (ARM).

An Adjustable Alternative To Interest-Only Mortgages

An adjustable rate mortgage could work as a nice alternative to an interest-only loan by giving you the option for lower payments while still paying down the principal on a regular basis.

*As of April 20, 2020, Rocket Mortgage® isn’t offering conventional adjustable rate mortgages (ARMs).

How Does An ARM Work?

All ARMs start out with an initial fixed-rate period of typically 5, 7 or 10 years. During this period, you get an initial interest rate that’s lower than the fixed rates available at the time, because the market doesn’t have to worry about projecting out their return on investment against inflation over the entire term. However, the interest rate can change.

At the end of this fixed-rate time frame, your interest rate will adjust up or down once per year based on current market conditions. Depending on the mortgage investor, there are a couple of different indexes used. The index number is then added to a margin to get your final rate for the year.

If you’re still in the home when it’s time for the rate to adjust, you may be able to refinance into a fixed rate. Otherwise, you can let your rate move with the direction of the market.

It’s also important to note that if your rate does increase, there’s a cap on how much it can rise initially in each subsequent year, as well as over the lifetime of the mortgage. Your rate can’t go up indefinitely, and you might be ready to leave your home by the time it adjusts.

Advantages Of An ARM

The primary advantage of an ARM over an interest-only mortgage is that you’re paying down a little bit of the principal with each monthly payment, which enables you to pay less in interest over time.

You can also enjoy a lower payment than a typical fixed-rate mortgage during the initial teaser period of the loan, which is when you’re only paying the low introductory rate. Unlike with an interest-only loan, the rate of an ARM won’t adjust once per year after the initial interest-only period is through. This means you get some of the advantage of an interest-only mortgage without the higher risk that comes along with it.  

Disadvantages Of An ARM

The big disadvantage of an ARM is that the rate does adjust after the initial fixed period. An ARM is less risky than an interest-only loan, but there remains a degree of uncertainty. Still, there are things you can do to minimize the impact.

Beyond switching to a fixed-rate mortgage, you can also pay down the principal by making extra payments every month. That way, when your mortgage does reamortize when the rate adjusts, your required monthly payment can be lower because you don’t have as much of the balance left. This lowers your monthly payment.

Get Started: Explore Interest-Only Mortgage Loans

If you think that an ARM might be right for you, you can check out options for this and other loans online through Rocket Mortgage®. If you’d rather get started over the phone, you can give one of our Home Loan Experts a call at (800) 785-4788. 

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