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Interest-only mortgages have a different structure than your usual fixed-rate loan. It can offer borrowers flexibility with low initial payments, but these will skyrocket about halfway through the loan term — which could ultimately make mortgage unaffordable. For this reason, interest only-mortgages are harder to come by, and qualify for.
When you take out a home mortgage loan to pay for the purchase of a house, you’ll agree to a set monthly payment amount. The funds from that payment are allocated into two different categories each month, with a portion going toward your principal, or the remaining borrowed balance, and the rest going toward interest, or the cost of borrowing that money from a lender.
With a typically-amortized loan, the majority of your payments will go toward interest in the first few years, slowly shifting each month until you’re primarily paying down your principal. However, with another type of loan, called an interest-only mortgage, the way you pay back the loan, and how it amortizes, is structured differently.
What is an interest-only mortgage?
As the name implies, an interest-only mortgage is one where a borrower only makes monthly payments toward the interest on that loan, at least for a period of time. During the interest-only period, borrowers will not be paying anything toward the principal balance of their home mortgage, so the actual amount of borrowed debt does not decrease.
Borrowers have the option of making additional payments toward their principal balance during the interest-only period, if they have extra funds available one month or experience a financial windfall. This can help reduce the overall cost of the loan and even the total loan length.
By default, though, all payments will go toward finance charges for the lender during the interest-only phase of the loan.
How payments work on interest-only mortgages
An interest-only loan is usually designed as an adjustable-rate mortgage, or ARM. This structure creates a loan with multiple phases:
- Stage 1: The borrower makes interest-only payments on the loan, at one set interest rate.
- Stage 2: The borrower begins making principal and interest payments (also called P&I), typically at a different (and perhaps even higher) interest rate.
The first stage of an interest-only mortgage loan usually lasts between three and 10 years, depending on the lender. The second stage can last up to 20 more years, potentially giving you up to 30 years to pay off your home.
What happens at the end of an interest-only mortgage?
As mentioned, principal payments will begin on an interest-only mortgage loan once the initial stage ends. At that time, your payments will switch to a typical P&I structure, which pays a little bit toward your principal balance and a little bit toward your interest charges.
This means that the monthly payment often jumps significantly higher than it was during the interest-only phase. Your interest rate may also change at this time.
The remaining loan term will be amortized like a “normal” fixed-rate mortgage loan until the debt is completely repaid. However, it’s important for borrowers to note that they will technically have a shorter period of time to pay off the principal amount of their home mortgage with this type of loan.
When taking out a traditional 30-year mortgage, borrowers are paying down their principal balance from day one, spreading that repayment out over three decades. But if the first 10 of those years were interest-only, the entire principal balance will need to be repaid in just 20 years (plus any additional interest).
The benefits of an interest-only mortgage
For some borrowers, this type of loan may make sense. Here are some benefits of interest-only mortgages.
Monthly payments will be lower initially
Since you’re exclusively paying interest in the first few years, an interest-only mortgage is quite affordable in the beginning. This offers flexibility for people who may not be earning a lot now, but expect to in the future.
Interest rates could be lower
Many interest-only mortgage loans are structured as adjustable-rate mortgages. This can sometimes result in a lower interest rate (during at least one of the loan phases) than you might find with a conventional home loan.
A home purchase may be more affordable
There are many situations where a home might not be affordable for you right now, but will be in the near future. This could be the case if you are trying to sell another property in the meantime, or if you’re looking to buy a second home. You might also be expecting a jump in salary soon or even a financial windfall, but want to buy a specific home before then. In any case, opting for an interest-only mortgage loan can put that property within reach now, without the burden of full payments off the bat.
You have the potential to lower your future payments
With both a traditional mortgage loan or an interest-only loan, you are able to make additional principal payments as desired. This can lower your overall cost of repayment, but with a traditional loan, it won’t do anything to change your monthly obligation. With an interest-only loan, however, any principal payments you make during the interest-only period will work to reduce your balance owed. Once you enter the P&I phase, your required monthly payment will be a bit lower than it would have otherwise been.
The risks of interest-only mortgages
For most homebuyers, interest-only mortgages aren’t the best idea. They generally result in a higher overall repayment and can even create a sudden financial hardship once full payments begin.
Here are some risks of interest-only mortgages:
No equity is being built in the home
With a traditional mortgage structure, borrowers begin paying down the principal balance of their loan immediately… albeit, slowly. This allows homeowners to build equity in their homes, which raises their net worth.
With an interest-only mortgage, however, you could go 10 years without paying down a single penny of your borrowed loan amount. This means that even a decade of payments later, you could have no equity established in your home. Depending on market trends, you might even find yourself in a negative equity situation if your home’s value has gone down.
Payments will increase substantially
Once the interest-only period ends, borrowers will begin making normal principal and interest payments. But if you’ve gotten comfortable with your monthly payment obligation, this sudden jump (often at a higher interest rate) can be jarring. If you haven’t adequately prepared your budget, it could create a serious financial hardship for your household.
Interest rates may also increase. Most traditional home mortgage loans have a fixed interest rate, which stays the same over the life of the loan. But since most interest-only mortgage loans are structured as adjustable-rate mortgages, the interest rate is likely to increase once the standard repayment term begins. Depending on your loan agreement and market trends, you could find yourself paying a lot more in interest than you’d expected.
Who offers interest-only mortgages?
Interest-only mortgages are offered by some of the same financial institutions that provide conventional mortgage loans: banks, credit unions, and online lenders.
However, you will find that not all mortgage lenders offer interest-only loan products, which are less readily available than they were before the housing crash in 2007. There may be strict requirements to qualify for an interest-only mortgage, too.
If you are interested in one of these loans, you may want to reach out to a loan officer at your existing bank, mortgage lender, or local financial institution. You could also contact a mortgage broker, who may be able to connect you with a lender.
Just note that these products aren’t the right fit for everyone, and be sure to weigh the actual costs before applying. As an alternative, you can check out other types of mortgage if you're buying a home.