What Is an Interest-Only Mortgage?
When you’re looking for lower payments on an upcoming home purchase or a way to take out an affordable second mortgage, you may come across interest-only mortgages. Interest-only mortgage lenders give buyers the ability to take advantage of much lower payments for a fixed period of time on the front-end of a loan.
While interest-only mortgage rates are attractive, there are a lot of factors to consider. These types of loans became popular during the housing crash of 2008 and caused a lot of financial hardship for buyers who didn’t fully understand the risks. In some unique situations, though, the loans may still prove a valuable resource.
What is an interest-only mortgage?
Loan payments are made up of two parts — the principal (the actual money borrowed) and the interest (the premium you pay as the cost of borrowing). An interest-only mortgage is a borrowing tool that allows you to forego making principal payments for a set number of years at the beginning of the loan. Instead, you’ll only pay the interest portion of your payments. Once that set period of time is over, you’ll begin making payments on the principal plus interest for the remainder of the loan until it’s paid off.
Interest-only mortgage lenders are much rarer than they used to be. During the housing crash of 2008, these loans were popular to allow people to buy bigger and more expensive homes and to help investors leverage further leverage capital. However, when things crashed, the risks of these loans became real. Today, you can still get an interest-only mortgage, but you are limited in your options.
How does an interest-only mortgage work?
Generally, interest-only mortgages are set up as adjustable-rate mortgages. An adjustable-rate mortgage (ARM) is a loan that has a fixed interest rate for a set period and then a variable rate after that for the remainder of the loan. An interest-only adjustable-rate mortgage generally allows you to pay only the interest during the fixed-rate period and then interest plus principal during the variable rate portion of your loan.
Applying for an interest-only mortgage is done through the same process as applying for a traditional mortgage through a mortgage lender. Because of the risk associated with these types of loans, many lenders will require you to have a better-than-normal credit profile. Additionally, you’ll need to make sure you are using a lender willing to offer the lending product. Unlike traditional mortgages, the lender is limited with options for mitigating their risk.
Who benefits from an interest-only mortgage?
Ideally, interest-only mortgages are beneficial in special circumstances. If you’re looking for smaller payments at the beginning of your mortgage, it may be a good fit. However, that’s generally not enough of a reason to warrant one. The loan type might be ideal for someone who is planning to have much higher income in the future, like a doctor or lawyer who just got out of school. Bear in mind, though, that at the end of the interest-only period, the payments will go up. Additionally, if it’s an adjustable-rate mortgage, the rates may increase as well.
In the past, interest-only mortgages have been used to help people qualify for larger homes or stretch investment dollars further. While this could sound appealing, it’s how many homebuyers got in financial trouble during the crash of 2008. Buyers hoped to sell their homes quickly with the rising market, but when things bottomed out, they were left holding the bag.
Pros and cons of an interest-only mortgage
Interest-only mortgage products have many positives and drawbacks to be aware of before deciding if it’s right for you.
- Lower payments: During the interest-only period, you’ll be paying significantly less than with any other mortgage product.
- Afford a bigger home: One of the factors that lenders use when calculating how much to approve you for is your debt-to-income ratio. When you are only taking on smaller interest payments, it allows the lender to approve you for a much more expensive home.
- Can still make principal payments: You are still allowed to make principal payments if you want during the interest-only period. This can give you more flexibility with how you pay your mortgage.
- Not building equity: Since you are only paying the interest portion of your loan during the interest-only period, you won’t be building any equity. All of your payments will go towards interest.
- Larger future payments: When the interest-only period ends, you’ll be responsible for paying the principal as well. However, instead of that cost being spread out over the entire loan, it will be over a shorter period of time, which means more per payment.
- It’s risky: If you’re not prepared to make the larger payments after the interest-only period, you can be setting yourself up for some hard times. Remember to always look at the full picture and not just the short-term appeal of lower payments.
How much do interest-only mortgages cost?
The costs for acquiring an interest-only mortgage are the same as you’ll see with a traditional mortgage. You’ll still need to pay closing costs. However, your payments for the interest-only period will be much lower than they would be with a traditional mortgage. Interest-only mortgage rates are generally higher than fixed-rates during the interest-only period and higher than rates you’d get with a traditional ARM.
Once you leave the interest-only period, though, your mortgage payments will increase to include paying off the principal over the remainder of the loan term. You should not expect to make a balloon payment (pay back all the skipped principal at once), nor should you accept a loan with these terms.