Is an interest-only mortgage a good idea? An interest-only mortgage can help you more easily afford the payments — but is it a wise move? Here, we explain how interest-only loans work and how to determine whether this type of mortgage is a good fit for you.
What is an interest-only mortgage?
An interest-only mortgage is exactly what it sounds like: a home loan that allows borrowers to make interest-only payments for a set amount of time, typically between seven years and 10 years, at the start of a 30-year term. After the introductory period ends, the borrower begins paying principal and interest for the remainder of the loan term at a variable interest rate.
Leading up to the housing crisis of the late 2000s, home-buyers 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. In the end, many people lost their homes.
Some lenders do 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 mortgages. Simply put: It is a riskier product.
How do interest-only mortgages work?
With an interest-only mortgage, the borrower is only required to 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 the initial payments are much lower. Borrowers must still pay taxes, 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 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 with interest for the remainder of the term. If it’s the latter, the loan will not amortize during the interest-only phase.
You can refinance after the interest-only period is over, although fees may 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, 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 $1,881 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 interest-only and traditional fixed-rate options, you’d pay a total of about $679,000, with around $349,000 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.
Candidates for interest-only mortgages
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.
For example, if you’re in medical school and want to buy a home, you’re likely on a tight budget now, but can count on a bigger paycheck when you establish your practice. If you flip houses, an interest-only loan might help you keep expenses down while you fix up the home. Then, you can use the sale proceeds to repay it. Likewise, if you plan to sell the home prior to the end of the interest-only period, you can take advantage of low monthly payments for now.
Pros and cons of interest-only mortgages
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:
You get more house for your money while buying some extra time to save up until you can afford a larger mortgage. That’s assuming you have a sound plan in place for when those larger payments eventually kick in.
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.
If you plan to move out of your home before the introductory period ends, interest-only loans can help homeowners set aside some extra money for other goals and investments.
You might benefit from an interest-only mortgage if rates are high now, but expected to fall by the time the interest-only period ends.
Since mortgage interest is tax-deductible, you might be able to reduce your tax burden.
Interest-only loans can benefit borrowers who know they’re going to be in a high-paying field in a few years, but may still be in school or completing a residency and will be on a lean budget in the interim.
The interest-only model may also be a good option for business owners with seasonal income, or professionals who receive regular bonuses and can make a large lump payment during their busy season.
After the introductory period ends, your interest-plus-principal payments will be much bigger than they would be with a conventional loan. Borrowers could experience payment shock when their monthly payments suddenly double or triple, or if they have to make a sizable balloon payment at the end of the initial period.
It’s tempting to spend and not invest the money saved during the interest-only portion of the loan.
As long as you’re only paying interest, you’re not building equity in your home.
You could become saddled with more house than you can afford, and your eventual income might not match your expectations.
If your home’s value depreciates, you could end up upside-down on your mortgage or risk negative amortization.
You could lose your house if you can’t make payments later in the loan term, or need to sell the home or refinance.
How to qualify for an interest-only mortgage
Interest-only loans have been harder to come by since the fallout of the housing crisis. Fewer lenders offer them, and banks have set stricter requirements to qualify.
Banks take on a bigger risk when they offer interest-only mortgages, so lenders look for well-qualified borrowers with a minimum credit score of 700 or higher, a debt-to-income (DTI) ratio of 43 percent or lower and a down payment of at least 20 percent to 30 percent. They might also scrutinize your assets and future income potential.
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. You would meet the same scrutiny and requirements as you would if applying for a first-time interest-only loan.
The same requirements of 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.
Interest-only mortgages are not ideal for most people, but they can be a useful tool for homeowners who fully understand the risks involved and can exercise extreme self-control. In exchange for having low mortgage payments on the front end, you could eventually face enormous monthly payments that your income doesn’t support — and if you choose not to pay down any principal during the initial period, your home won’t gain equity.
The few banks that offer these loans are picky about who they give them to, as well. You will need to have exemplary credit, substantial assets and high earning potential to qualify.
Overall, if you’re a careful saver who’s in a position to take on a significant monthly payment in the long term, you might be a good candidate for an interest-only mortgage.
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