Usually, when you make a mortgage payment, part of it goes toward your loan’s principal and the rest goes toward your loan’s interest. An interest-only mortgage lets you pay only the interest on your loan for a specific number of years, after which point you need to pay both principal and interest.
An interest-only mortgage reduces your monthly payments for the first several years of your loan, often up to 10 years. However, your monthly payments will increase once you start paying principal in addition to interest. Here’s what you need to know about interest-only mortgages to see if this borrowing option is right for you.
Key Takeaways:
- An interest-only mortgage lets you pay only interest on your loan for a period of time.
- An interest-only mortgage could make sense if you want to get into a home sooner and expect your income to increase in a few years.
- There are risks involved with an interest-only mortgage, like increased payments and winding up with negative equity.
How Do Interest-Only Mortgages Work?
An interest-only mortgage allows you to pay only the interest on your loan for a set period of time, typically up to 10 years. This reduces your monthly payment initially, but your principal remains unchanged. Once you start paying both interest and principal, your monthly payments will increase significantly, as you’ll have less time to pay down the principal to zero.
Many interest-only loans are adjustable-rate mortgages (ARMs). With an ARM, you pay a fixed introductory interest rate that is typically lower than the rate on a fixed-rate loan. After it expires, your interest rate will adjust upward or downward according to market rates.
Interest-Only Mortgage Example
Let’s say that after making a 20% down payment, you take out a 30-year mortgage for $400,000 with a 6% APR and a 7-year interest-only period. During those first 7 years, your mortgage payment will be $2,000. After 7 years, you’ll have paid $168,000 in interest and your principal balance will still be $400,000. (With a 20% down payment, you won’t have to worry about PMI being tacked on to your monthly payments.)
From there, your monthly payment will increase to $2,675 to pay off the principal with interest over the remaining 23 years of your loan term (assuming the interest rate remains the same). During those 23 years, you’ll also pay $338,407 in interest. When we add the $168,000 of interest paid during your first 7 years of loan payments, we get a total of $506,407 in interest.
Keep in mind that your interest rate will generally adjust with an interest-only mortgage, affecting your monthly payment and how much interest you pay. For this example, though, we’ll use the same 6% interest rate for the life of the loan.
Now, let’s compare the interest-only mortgage example above to a standard 30-year, $400,000 mortgage at 6% interest. In that case, you’re looking at monthly payments of about $2,398 for the life of your loan. You’re also looking at paying a total of $463,353 in interest.
So as you can see, while an interest-only mortgage might give you lower monthly payments for a period of time, it can cost you more in interest over the life of the loan. In this example, the extra cost of interest is $43,054.
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Should You Consider An Interest-Only Mortgage?
An interest-only mortgage could make sense if you expect your income to increase but need to keep your short-term housing costs low and/or if you want to buy a home sooner. It can also be a helpful option if you expect to sell the home after a few years and don’t need to worry about higher monthly payments. Other times, buyers use an interest-only mortgage to buy a second home.
If you plan to own the home longer than the interest-only period, you’ll need to make sure you’ll be able to afford the monthly payments when they increase (though you may have the option to refinance into a new mortgage that comes with comparable payments to what you’re used to). You’ll also need to understand that not paying down the principal means the only way you can build equity is if your home increases in value.
If your home doesn’t increase in value, you’ll have no equity, which may make it difficult to sell or refinance your home. You could also wind up with negative equity, which could be a problem if you need to sell your home.
Negative equity is when the amount you owe on your mortgage is higher than the current market value of your home. You may be able to refinance if you have negative equity in your home, but that will depend on your lender’s policy, as well as your general credit profile.
Making a larger down payment on your home, however, can help offset the risk of ending up with negative equity. Even if home values fall, if you have enough equity due to your down payment, you may not end up underwater on your mortgage.
How To Qualify For An Interest-Only Mortgage
Interest-only mortgages typically have stricter eligibility requirements. Lenders usually require a higher credit score, a low debt-to-income ratio and significant savings for a down payment.
Each lender, however, sets their own requirements. So the only way to know if you’ll qualify is to apply.
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Pros And Cons
Here are some advantages of interest-only mortgages:
- You can make a smaller monthly payment for a set period of time.
- You can enjoy lower interest rates than a fixed-rate mortgage – at least at first.
- You’ll have more room in your budget for other expenses while your payments are lower.
- Lower initial payments may help you afford a more expensive home or get you into a home sooner.
- You can pay off your loan faster with extra principal payments, if your lender allows them.
- It can be a helpful mortgage for an investment property you plan to rent out.
Here are some disadvantages of interest-only mortgages:
- Your monthly mortgage payments will eventually increase.
- There are stricter eligibility requirements.
- Not paying down your principal means you can build equity only if your home increases in value.
- Interest-only loans are generally ARMs, meaning your interest rate will adjust (either higher or lower) after an agreed-upon period.
- You could end up paying more in interest over the life of the loan than with a conventional mortgage.
- You’ll owe the lender the same principal amount years into the mortgage.
- If the value of your home decreases, you could end up with negative equity.
- You might be unable to sell or refinance before the end of the interest-only period.
- If you sell the home before the end of the introductory period, you will make no money on the deal unless the home has substantially increased in value.
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Alternatives To An Interest-Only Mortgage
If an interest-only mortgage doesn’t sound right for you, here are some other options to consider:
- Conforming conventional loans: This is the most common loan type in the United States. It has a maximum loan amount and typically costs less than a Federal Housing Administration (FHA) loan but has stricter eligibility requirements.
- FHA loans: FHA mortgages can be cheaper for borrowers with a lower credit score and a smaller down payment. However, conventional mortgages tend to be cheaper than FHA loans if you can put at least 10% down and have good credit.
- Veterans Affairs loans: No down payment is required, but VA loans are available only to eligible military service members, veterans and their surviving spouses.
- U.S. Department of Agriculture loans: These loans are aimed at low- to moderate-income borrowers looking to buy a home in specific rural areas. No down payment is required for USDA loans.
- Balloon loans: These loans come with smaller monthly payments for a period of time and then require a large lump-sum payment at the end of the loan.
FAQ
Here are some common questions about interest-only mortgages.
The Bottom Line: What to Consider Before Signing an Interest-Only Mortgage
If you’ve ever found yourself wondering “what is an interest-only loan,” now you have an answer. Now, you need to decide if one is right for you.
Interest-only mortgages can be helpful for borrowers who expect their income to increase. If you can benefit from lower monthly payments for the first several years of your mortgage, but know you’ll be able to afford larger payments down the line, an interest-only loan may be worth looking at.
However, before you sign an interest-only mortgage, understand the risks. You won’t be building equity in your home for several years, and you might struggle with higher monthly payments once you’re on the hook for them. Make sure you fully grasp the pros and cons before moving forward.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
