An interest-only mortgage is a home loan that allows borrowers to only make interest payments for the first several years. After that initial period, they must start repaying the principal.
This type of nonconforming loan is less common among borrowers, but some people could benefit from having one. Buying a home is a big financial commitment, so it’s smart to explore your mortgage options to ensure that you’re making the right choice for your finances.
Learn more about interest-only mortgages in this guide:
- What Is an Interest-Only Mortgage?
- Types of Interest-Only Mortgages
- When To Consider an Interest-Only Home Loan
- How To Get an Interest-Only Mortgage
- The Bottom Line on Interest-Only Mortgages
What Is an Interest-Only Mortgage?
An interest-only mortgage is a nonconforming loan where the borrower can pay only the mortgage interest for an initial period. Nonconforming loans don’t adhere to the rules set by Fannie Mae and Freddie Mac, which are government-sponsored enterprises that back conforming loans. That’s why the features and requirements of interest-only mortgages can vary widely.
Of course, borrowers must repay the principal balance on an interest-only mortgage. But repayment isn’t expected until after the interest-only period ends.
Once the interest-only period is over, the borrower may have a few options to pay off the loan:
- Repay the balance with a lump sum.
- Begin making monthly payments that include the principal.
- Refinance the mortgage, if qualified.
Depending on market conditions or the borrower’s financial situation, refinancing or selling the home might not be an option. As such, it’s critical for borrowers to prepare their finances for the end of the interest-only period.
How does an interest-only mortgage work?
Interest-only mortgages start out with borrowers paying just the interest on the loan, which means they don’t need to make any payments toward the principal. As a result, borrowers have lower monthly payments for the first few years of the loan term.
Typically, the interest-only period lasts for three to 10 years. When the interest-only period expires, the borrower’s monthly payment becomes more expensive, because they must start repaying the principal.
Let’s use an example to see how the costs break down over the life of a 30-year mortgage with a 10-year interest-only period versus a traditional 30-year, fixed-rate mortgage:
Interest-Only Mortgage vs. 30-Year, Fixed-Rate Mortgage:
$250,000 Loan, 4% Interest Rate
|Cost||30-Year Mortgage With a 10-Year Interest-Only Period||Traditional 30-Year, Fixed-Rate Mortgage|
|Monthly payment, first 10 years||$833||$1,194|
|Monthly payment, final 20 years||$1,515||$1,194|
|Total interest paid||$213,588||$179,673|
The interest-only mortgage in the example above offers a lower monthly payment compared with the other loan — but it doesn’t last forever. The borrower experiences a big spike after 10 years, with their monthly payment increasing by about 82%. Plus, they pay far more in interest over the life of the loan — a difference of $33,915.
Benefits of an interest-only home loan
Interest-only home loans come with certain benefits:
- Smaller initial monthly payments. The interest-only period allows borrowers to make a lower monthly payment for several years.
- More financial flexibility at first. A cheaper mortgage payment means that borrowers can use their cash on things other than their home, such as investing or an emergency fund.
- Rebuild savings faster. With a lower monthly payment, borrowers could recoup the upfront costs of buying a home at a quicker pace.
- Lower interest rate to start. Most interest-only mortgages have an adjustable-rate structure. Adjustable-rate mortgages typically offer lower initial interest rates than fixed-rate mortgages.
Drawbacks of an interest-only home loan
As with all loan products, there are drawbacks to consider with an interest-only mortgage:
- Interest payments don’t build equity. Home equity is the difference between the property’s value and how much the borrower still owes on their mortgage. Interest-only payments won’t make a dent in the principal balance.
- The borrower risks losing equity. If property values fall, the borrower could get stuck paying off a mortgage balance that’s higher than the current value of the home — and lose the equity from their down payment.
- Larger payments are looming on the horizon. The borrower’s smaller monthly payments aren’t permanent. The sharp increase after the interest-only period ends could scramble the borrower’s budget if they aren’t prepared.
- Potential rate increases. Since interest-only home loans are usually structured as adjustable-rate mortgages, the borrower may face higher interest rates in the future.
Types of Interest-Only Mortgages
If you’re considering an interest-only home loan, there are two types of mortgages to check out. Let’s take a closer look at adjustable-rate vs. fixed-rate mortgages.
Interest-only adjustable-rate mortgages
Adjustable interest rates are the most common for interest-only home loans. Following an initial period with a fixed interest rate, the rate on an adjustable-rate mortgage can fluctuate at regular intervals based on current market rates.
You’ll find these loans advertised in this example format: 5/1 ARM. The first number represents the initial period when the interest rate is fixed, which is five years in this case. The second number indicates how often the interest rate will change after that — once per year.
An interest-only ARM may offer more-affordable payments at first, thanks to lower initial rates and the interest-only period. But borrowers will face significantly higher payments — up to double or triple the original payment — when these periods are over. This is because the borrower could see their interest rate go up, and they also must start repaying the principal.
Fixed-rate interest-only mortgages
Fixed-rate interest-only mortgages are difficult to come by, but it can be helpful to understand how they work since you may still encounter this option.
With a fixed-rate mortgage, the borrower’s interest rate won’t change throughout the life of their loan. Following the interest-only period, the borrower starts repaying the principal in addition to the interest. The monthly payment increases significantly partly because the borrower has less time, or a shorter portion of the loan term, to pay off the principal.
When To Consider an Interest-Only Home Loan
Despite their drawbacks, interest-only mortgages could be a useful option for some borrowers.
“If a borrower buys a property with a specific exit plan, or if a borrower’s income is expected to rise faster than interest rates, then an interest-only mortgage may be the best option,” says Asher Rogovy, chief investment officer at Magnifina, an investment advisory firm in New York City.
Additionally, opting for an interest-only home loan could free up funds to use for other purposes. For example, borrowers might decide to invest in other assets while their mortgage payment is low.
Another reason to get an interest-only mortgage is when the borrower receives variable income from commissions, seasonal work, or freelancing, and they want the financial flexibility that interest-only payments provide.
But borrowers should make sure to prepare themselves for the inevitable increase in their housing expenses.
“Interest-only mortgages can be risky during periods of rising interest rates as these loans are typically made with an adjustable rate,” Rogovy says. “It’s common for borrowers to neglect to properly anticipate or budget for a higher monthly payment.”
How To Get an Interest-Only Mortgage
If you’ve carefully weighed your options and decided that an interest-only mortgage is your best bet, then it’s time to apply.
It can be difficult to get approved for an interest-only home loan. Typically, interest-only mortgages require borrowers to have a high credit score, a low debt-to-income ratio, plenty of savings, and a large down payment. If you check all the boxes, seek out a mortgage lender that offers interest-only home loans.
Interest-only mortgage lenders
Here are a few lenders that work with interest-only mortgages:
- Chase. This bank offers interest-only mortgages with an initial fixed interest rate for five, seven, or 10 years, which converts to an adjustable rate afterward. The interest-only period lasts 10 years. For qualified borrowers, Chase will reduce the minimum payment if they pay down the principal during the interest-only period.
- Axos Bank. This bank allows qualified borrowers to pay just the interest on their mortgage, or make principal payments as well during the interest-only period.
- Logix. This credit union offers a 7/1 interest-only ARM. Qualified borrowers can make interest-only payments for an initial 10-year period.
This list is current as of March 16, 2022, but lenders may change their offerings at any time.
You could also check out the options from local lenders, or ask your real estate agent if they have any clients who’ve gotten an interest-only mortgage.
The Bottom Line on Interest-Only Mortgages
Interest-only mortgages are just one of many options for qualified borrowers. Before pursuing this type of loan, consider the risks of interest-only mortgages — like not being able to afford higher monthly payments down the line. Depending on your situation, it could make more sense to look at other mortgage options and lock in a steady monthly payment for the life of the loan.
If you aren’t sure whether an interest-only mortgage is the right loan for your needs, it’s best talk to a financial advisor.