Interest-Only Mortgages: What You Need to Know

Interest-only mortgages allow borrowers to defer paying off their loan and instead pay only the cost of borrowing money, i.e. interest. This allows qualified homebuyers to make low initial payments for a set period of time, which is typically 5 to 10 years. After the interest-only period ends, most borrowers refinance into a different mortgage or sell their home to pay off the loan with a lump sum. Interest-only loans are a good choice primarily for high net-worth homebuyers, as they require large down payments and carry more risk.

Interest-Only Mortgages Explained

An interest-only mortgage is a home purchase loan that allows homebuyers to make low monthly payments during the first few years of their mortgage. Instead of paying for both principal and interest—which are the primary components of a normal monthly mortgage payment—interest-only borrowers elect to defer their principal payments to a later date.

Typically, interest-only mortgages have a five to ten year period with no principal payments, followed by a 30 year period with normal payments. As such, the outstanding loan amount on an interest-only mortgage doesn't decrease during the initial payment period. However, most borrowers pay off or refinance their interest only mortgage before the normal payment period begins.

Takeaways

  • Initial monthly payments only include interest
  • Loan balance does not decrease until end of interest-only period
  • Borrowers tend to get out of mortgage before full payment period begins

While interest-only mortgages can save money during the initial borrowing period, they are not generally used as a vehicle for affordability. Rather, interest-only mortgages are primarily taken on by wealthy homebuyers, or by those who have reliable but inconsistent income streams. This is because the payment structure enables high-income borrowers to put their money towards other investments rather than spend it on building equity in their home. And for someone like a business owner or entertainer who has an erratic cash flow, the deferment of principal can help make home buying more accessible.

Because interest-only loans are riskier investments for lenders, the qualification criteria tend to be stricter than for normal home loans. Depending on the size of the loan, the minimum required down payment can be 15% or more—whereas conventional mortgages only require 3% down. If you're looking for an affordable mortgage option with more lenient requirements, you might want to consider a different option like an adjustable rate mortgage or an FHA loan.

Paying Off An Interest-Only Mortgage

In theory, interest-only mortgages are paid off just like regular 30 year mortgages once the principal deferment period ends. In reality, borrowers with interest-only mortgages rarely stay with them long enough to begin making full principal and interest payments. Instead, most borrowers will either sell their home or refinance into a different mortgage. Interest-only borrowers who sell their home pay off their mortgage with the cash received from the sale, while those who refinance pay off their interest-only mortgage with a different home loan.

Making a Balloon Payment

Some borrowers pay off their interest-only mortgage in cash with a balloon payment. This means that the mortgage is paid off in a lump sum all at once, rather than in a series of fixed payments like for other installment loans. For example, regular mortgages are paid off through a process called amortization. Through a series of fixed interest and principal payments, the mortgage's balance gradually amortizes, or decreases, until it's paid off completely. In contrast, the initial payments towards interest-only mortgages don't go towards paying off the loan at all; they only cover the borrowing cost.

Refinancing

At the end of the interest-only period, many homeowners choose to refinance their mortgage. This allows them to change into a loan with more favorable terms, which usually means switching into a regular mortgage and paying down the principal over 15 or 30 years, or switching into another interest-only mortgage and deferring the loan pay-off for another 5 or 10 years.

Advantages and Disadvantages of an Interest-Only Mortgage

Interest-only mortgages provide more financial flexibility than traditional mortgages, but they shouldn't be used by everyone. They carry more risk for the average homebuyer, especially if you have any uncertainty about your future earnings and income.

ProsCons
  • Lower initial monthly payments
  • Allows borrowers to finance other investments
  • Can be used to purchase expensive home
  • More risk because of spike in payments
  • Requires large down payment
  • Interest-only payments don't build equity

Interest-only mortgages can be a savvy financial move for the wealthy individual who plans to move or sell their house after a few years. Deferring the principal payment can save thousands during the life of the mortgage, even if it's only taken out for a few years. Additionally, if you buy in a housing market with rising prices, selling the house before the end of the interest-only period can potentially net some large returns.

However, the downside of interest-only mortgages is that they're extremely risky for all but the most qualified homebuyers. In most cases, it's not advisable to take out an interest-only mortgage unless you're absolutely sure that you can pay off the principal once it hits the regular amortization schedule. If you don't have the current liquidity to do this, it can be a risky move to rely on future income as a way to pay down the house. It's most important to consider how big of a mortgage you can actually afford.

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