Benefits, Risks, and How They Work
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- For the first few years of an interest-only mortgage term, you’ll just pay interest each month.
- You might not qualify for an interest-only mortgage; you need a high credit score among other things.
- You won’t build equity in your home until you start making payments toward the mortgage principal.
Mortgage rates should continue to trend down in 2024, but house prices will probably remain high — in fact, prices could even increase a bit as people who have been waiting for rates to drop enter the housing market and competition rises.
With decreasing mortgage rates and increasing home costs, an unusual type of mortgage might start to sound appealing: the interest-only mortgage.
What is an interest-only mortgage?
A mortgage is a loan for buying a home. When you get a regular mortgage, your monthly payments cover two main expenses: your mortgage principal and your mortgage interest.
An interest-only loan works a little differently.
Definition and basic concept
With an interest-only mortgage, you only make payments toward the interest, not the principal, each month.
The interest-only period comes with a short term, usually 10 years or less. After that, you’ll start making full interest-and-principal payments or will owe the remaining balance all at once.
How interest-only mortgages work
Interest-only mortgages are typically adjustable-rate mortgages, or ARMs, meaning the rate stays the same for while, then changes periodically.
For example, you may have a 10/20 interest-only ARM. This means you’ll repay your mortgage over 30 years — the first 10 years will be interest-only payments, and the remaining 20 will be payments toward both the interest and principal. Terms vary by lender, but chances are your adjustable rate will change once per year.
Some lenders provide the option to sign up for a type of balloon mortgage. You’ll make interest-only payments for the first few years, then pay the entire principal in one lump sum. This method isn’t as common as switching to interest-and-principal payments, though.
Benefits of interest-only mortgages
Interest-only mortgages can have some notable benefits for those who use them. These include:
Lower initial monthly payments
The biggest draw of an interest-only mortgage is that you’ll pay less each month than if you were putting money toward the principal. Low payments can help you afford a home sooner.
Increased cash flow
Since monthly payments are much smaller on an interest-only loan than they would be on a traditional one, it can free up a lot of household cash flow — at least for the initial few years of the loan. This could make it easier to achieve other financial goals or just lighten the load a bit.
Investment opportunities
That freed-up cash flow could make for other investment opportunities, too. You may be able to invest more money in the stock market, your 401(k), or even other real estate purchases that can help you build your wealth.
Risks of interest-only mortgages
Interest-only mortgages can be risky, especially once your interest-only period expires. Here are some disadvantages to keep in mind before you take one of these loans out:
Potential for higher payments
Most interest-only mortgages come with an adjustable interest rate. The good news is that adjustable rates are starting lower than fixed rates right now. But if rates rise in the future, your adjustable rate could increase, too.
Your payments will also increase once your interest-only period expires. This could put a strain on your household budget.
Risk of not building equity
It takes a long time to build equity with an interest-only mortgage, because you won’t make any progress on the principal owed for several years. If you want homeownership to be a significant part of your financial portfolio, an interest-only mortgage isn’t a good tool to help you get there.
Market risks
Not only will you not build equity during the interest-only period, but you could actually lose equity due to changing market conditions.
The housing market may decline, for example, or your home might lose value for some other reason. Because of this, getting an interest-only mortgage with plans to sell before the interest-only period ends is risky.
Types of interest-only mortgages
There are typically two types of interest-only mortgages you can choose from. These include:
Fixed-rate interest-only mortgages
These have a consistent interest rate for the entire loan term. While your payments may change once you start paying toward your principal balance, the rate of interest you’re paying will never fluctuate for as long as you have the loan.
Adjustable-rate interest-only mortgages
These have interest rates that can change periodically. That means that if your rate goes up, your payment does, too — even if you’re still in the interest-only period.
Is an interest-only mortgage right for you?
Interest-only mortgages are only right for certain borrowers. See below to see if one might be right for you:
Considerations before choosing
Your income is the biggest consideration with an interest-only mortgage. For instance, this type of mortgage could be useful if you’re confident you’ll earn more money down the road. If you know you’re going to get your annual bonus at the end of the year or you’re due for a raise soon, it could be the right fit.
How stable your income is should play in, too. If you have earnings that fluctuate or are unpredictable, it might not be smart to get a loan that’s also hard to predict.
Comparing with traditional mortgages
When compared with traditional mortgages, interest-only options have lower payments up front and bigger ones down the line. You’ll need to know your household finances well to decide which one works for you best.
Financial goals and risk tolerance
Finally, think about your financial goals and appetite for risk. Is freeing up cash right now worth it for a little more risk down the road? How important is building equity in your house? You need to know all these things before deciding what type of mortgage is best.
How to qualify for an interest-only mortgage
Each lender has its own rules surrounding who qualifies for an interest-only mortgage. But in general, requirements are more stringent than for other types of mortgages. You can usually expect to need the following:
Down payment and equity
You’ll probably need at least a 20% down payment to qualify for an interest-only loan. These loans tend to be riskier for lenders to take on, so the more you put down, the better.
Credit score requirements
The same goes for your credit score. Since these loans are a bit riskier than traditional options, you will typically need a higher credit score, too — think 700 or above.
Income and employment verification
Lenders will also want to look at your employment history and income trends, as well as verify your current job with your employer. This ensures you’re able to make your payments, both now and once the interest-only period expires.
FAQs on interest-only mortgages
An interest-only mortgage allows you to pay only the interest for a specified period, typically five to t0 years. After that, you’ll switch to principal-and-interest payments or repay the full balance all at once.
After the interest-only period, you must start paying both principal and interest, resulting in higher payments. Some interest-only loans require a balloon payment at the end of your interest-only period.
They can be beneficial for those needing a lower upfront payment or those looking to invest extra cash elsewhere.
Yes, you can refinance into another interest-only mortgage or a traditional mortgage.
