What is an interest-only mortgage and how does it work?

An interest-only mortgage allows you to pay only the interest on your loan for a set period. This type of mortgage can help you more easily afford the payments in the short term — but not without some drawbacks. Here’s what to know.

What is an interest-only mortgage?

An interest-only mortgage is a home loan that allows borrowers to make interest-only payments for a set amount of time, typically between seven and 10 years, at the start of a 30-year term. After this introductory period ends, the borrower pays principal and interest for the remainder of the loan at a variable interest rate.

In the early 2000s, homebuyers gave in to the instant gratification of mortgages that allowed them to make interest-only payments at the start of the loan, so long as they took on supersized payments over the long term. This was one of the risky practices that contributed to the housing crisis in 2007, leading to the Great Recession. In the end, many people lost their homes.

Some lenders still offer interest-only mortgages today — often as an adjustable-rate loan — but with much stricter eligibility requirements. They are now considered non-qualified mortgages (non-QM loans) because they don’t meet the backing criteria for Fannie Mae, Freddie Mac or the other government entities that insure and repurchase mortgages. Simply put: an interest-only mortgage is a riskier product.

How do interest-only mortgages work?

With an interest-only loan, you’ll pay interest at a fixed or adjustable rate during the interest-only period. The interest rates are comparable with what you might find with a conventional loan, but because you’re not paying any principal, the initial payments are much lower. However, they may still include property taxes, homeowners insurance and possibly private mortgage insurance (PMI).

Even though you’re only required to pay the interest at first, you still have the option of paying down the principal during the loan’s introductory period.

At the end of the initial period, borrowers must repay the principal either in one balloon payment at a set date, which can be very large, or in monthly payments (that also include interest) for the remainder of the term. These payments of principal and interest are going to be larger than the interest-only ones. And, because your principal payments are being amortized over only 20 years instead of 30, those payments will be higher than those of someone with a traditional 30-year loan.

You can refinance after the interest-only period is over, although fees will likely apply.

Example of an interest-only mortgage

Say you obtain a 30-year interest-only loan for $330,000, with an initial rate of 5.1 percent and an interest-only term of seven years. During the interest-only period, you’d pay roughly $1,403 per month.

After this initial phase, with our interest-only loan example, the payment would rise to $2,033 per month — assuming your rate doesn’t change. Many interest-only loans convert to an adjustable rate, so if rates rise in the future, yours will, too (and vice versa).

With a 30-year fixed-rate mortgage for the same amount, you’d pay $1,882 per month. This includes principal and interest, and also accounts for the higher rate on this type of loan — in this case, 5.54 percent.

With both the traditional fixed-rate option and our interest-only loan example, you’d pay a total of about $677,000, with around $347,000 of those payments going toward interest. As you can see, however, you’d ultimately have a higher monthly payment with an interest-only loan. If your interest-only loan requires a balloon payment instead, you’d be on the hook for several hundred thousand dollars.

How to qualify for an interest-only mortgage

Interest-only loans have been harder to come by since the housing crisis of the mid-2000s. Fewer lenders offer them, and banks have set stricter requirements to qualify.

Banks generally only offer an interest-only mortgage to a well-qualified borrower. You’ll likely need:

• A credit score of 700 or more
• A debt-to-income (DTI) ratio of 43 percent of less
• A down payment of 20 percent or more
• Solid proof of future earning potential
• Ample assets

Should you consider an interest-only mortgage?

The best candidates for an interest-only mortgage are borrowers who have full confidence they’ll be able to cover the higher monthly payments when they arise. This kind of home loan might be right for you if:

• You’re in graduate school and want to keep repayments low for now — but anticipate having a high-paying job in future
• You have a trust that will start releasing assets at a future date
• You flip houses and need to keep expenses down during the remodel
• You expect to move before the end of the introductory period

Interest-only loans can be a prudent personal finance strategy under certain circumstances, but they’re not a good idea for everyone. Here are some pros and cons:

Pros of interest-only mortgages

• You get more house for your money. You can enjoy a larger home for less money while you save up for a larger mortgage. That’s assuming you have a sound plan in place for when those larger payments eventually kick in. Bankrate’s affordability calculator can help you estimate how much house you can afford.
• Interest-only payments are smaller than conventional mortgage payments. The initial monthly payments on interest-only loans tend to be significantly lower than payments on conventional loans, and the interest rate may be fixed during the first part of the loan. Bankrate’s interest-only mortgage calculator can help you determine what your monthly payment would be.
• You kick higher payments down the road. You can delay making large mortgage payments or avoid them entirely if you plan to move out of your home before the introductory period ends.
• If interest rates are high now, you can avoid them. If rates are anticipated to be lower in the future, you can keep your monthly payments relatively affordable and then reap the benefits of lower rates by the time the interest-only period ends.

Cons of interest-only mortgages

• You won’t build home equity. As long as you’re only paying interest, you’re not building equity in your home. And if your home’s value depreciates, you could end up upside-down on your mortgage or risk negative amortization.
• You might get an unaffordable payment after the interest-only period. You could encounter serious sticker shock when the interest-only period ends, and your monthly payments suddenly double or triple, or if you have to make a sizable balloon payment at the end of the initial period.
• You’ll be at the mercy of market interest rates. If rates have risen since the loan originated, when the intro period ends, you may have a payment much higher than you want.
• If your income changes, the home may be unaffordable down the road. Your anticipated future income might not match your expectations, saddling you with more house than you can afford.

Alternatives to an interest-only mortgage

Before you take on this kind of loan, ask yourself: what is an interest-only mortgage going to do for you? Make sure you think long-term.

If you want to avoid this higher-risk form of home financing, you can explore other types of mortgages. Many adjustable-rate mortgages also have a long, low-interest introductory rate period — and, since the payments include some principal, you’ll be building equity during it.

If you’re drawn to interest-only loans because of the low monthly payment, explore government-backed loans like one from the Federal Housing Administration (FHA). These can give you more affordable payments without the future jump that comes with an interest-only mortgage.

Can I change to an interest-only mortgage?

It is possible to refinance a traditional mortgage to an interest-only loan, and borrowers might consider this option as a way to free up money to put toward short-term investments or an unexpected expense. So, how do interest-only loans work as a refi? You would meet the same scrutiny and requirements as you would if applying for a first-time interest-only loan.

The same eligibility criteria for refinancing also apply, and some lenders may raise the bar since it is a higher-risk loan.

In any refinance, you will need to receive a home appraisal and pay closing costs and fees. Refinancing can cost 3 percent to 6 percent of the home’s total amount. In addition, if you have less than 20 percent equity in your home, you will be required to pay PMI.

 

Additional reporting by Kacie Goff