How Do Interest Only Mortgages Work?

How do interest-only mortgages work: structure, payments and examples

An interest-only mortgage has two phases: one in which you pay only interest, and one in which you pay principal and interest.

In the interest-only phase, you make smaller payments, usually for a period of three to 10 years, that include only interest. Your principal loan balance won’t decrease at all during this first phase, so while your initial payments are lower, you won’t be building any equity.

At the end of the interest-only phase, you’ll need to start repaying your principal balance, so your payments will increase to include both principal and interest. In this phase, your principal will start decreasing, and you’ll begin to build equity.

Your payments in the second phase will usually be higher than they would have been if you had taken out a traditional mortgage. This is because you’ll repay your principal over a shorter period due to the first phase cutting into your repayment timeline.

Example:

• You secure a 30-year interest-only mortgage with a principal balance of $300,000, an interest rate of 5% and a loan term of 30 years with a 10-year interest-only phase.
• Your payments during your interest-only phase would be $1,250 per month for 10 years, and your principal balance doesn’t change during this period.
• After 10 years, your payments increase to $1,980 using standard amortization rates, which you’d pay for 20 years.

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Interest-only mortgage payment structure

Interest-only mortgages usually have the same total loan term as traditional mortgages: 30 years. That typically includes a period of 10 years, during which you only pay interest, and then a period of 20 years, during which you start paying down your principal balance. Interest-only periods usually range from five to 10 years, and total loan terms range from 20 to 40 years.

Your payment amounts during these periods can vary widely due to many factors, including your mortgage amount, your interest rate and more. Most interest-only mortgages use a fixed interest rate for the first phase of your mortgage and a variable interest rate for the remainder of the loan.

You can use the checklist below to ensure you understand your loan’s structure and specifics:

• Confirm the length of your interest-only period (usually three, five, seven or 10 years).
• Identify if the interest rate is fixed or adjustable (usually adjustable)
• Calculate your payment increase after the interest-only period ends.
• Check for balloon payment requirements at the end of the loan.
• Ask if you can make extra principal payments during the interest-only term.
• Review if the loan allows for early payoff without penalty.
• Use a detailed mortgage calculator that handles both payment phases.

The average mortgage in the U.S. is for $366,000. Using an example interest rate of 5%, your initial payments during your interest-only phase would be $1,525. Then, your monthly payments could rise 30% to 60% or more during the second phase of your mortgage. Remember that these numbers vary widely, especially because most interest-only loans have variable rates.

Like all adjustable-rate mortgages (ARMs), interest-only mortgages come with some built-in uncertainty. It’s a good idea to use a mortgage calculator to estimate payments during both mortgage phases before committing to this loan product. If your payments in your second phase exceed 40% of your gross income, you should consider other options.

Is an interest-only mortgage right for you?

Interest-only mortgages aren’t ideal for everyone, so identifying if it’s the right fit for you is a good place to start when looking for a home loan. Since monthly payments are initially lower and then spike after the first three to 10 years, they can be particularly useful for the following types of people:

• Those who know their income will increase in the coming years.
• Investors who plan to flip the property before the interest-only period ends.
• Investors who want to maximize cash flow early on.
• Homeowners who plan to refinance before the interest-only period ends.
• Retirees who plan on downsizing before the interest-only period ends.

It’s important to remember that interest-only loans often mean paying more in interest over time than you would with a traditional loan product because of the static principal during the interest-only period. You should speak with a reliable mortgage lender and compare both initial and long-term affordability of different loan options.

You may want to avoid interest-only loans in the following cases:

• Your monthly payment after your initial interest-only period will be 40% or more of your gross income.
• You expect to live in your home for a long time and want predictable payments.
• Your income fluctuates and you don’t have a financial cushion in place.

Here’s a quick comparison with a traditional mortgage to illustrate the differences. These assume a $366,000 mortgage and a 5% initial interest rate.

Interest-only mortgage risks and considerations

Qualifying for an interest-only loan doesn’t necessarily mean it’s a good option, nor does it mean that it’s a better option than a fixed-rate mortgage. There are some inherent risks and drawbacks you should think about before committing.

• Interest-only loans usually have adjustable rates, which means your monthly payment is unpredictable.
• There’s a much higher risk of being “upside down” on an interest-only loan, which is when you owe more than your home is worth.
• Buyers with a healthy debt-to-income (DTI) ratio could have a higher ratio if interest rates spike.
• You may experience payment shock when your monthly payment suddenly jumps after the interest-only period, even if you prepare.
• You’ll often end up paying more over time with an interest-only mortgage because you have no amortization during the interest-only period.
• You won’t build any equity during the first phase of your interest-only mortgage.

Even if you qualify for an interest-only loan, make sure you compare lifetime loan costs using a full amortization schedule and not just early payment savings. Also, don’t justify an interest-only loan with the possibility of refinancing down the line, as market conditions change and may make refinancing unrealistic.

» NEXT: Types of mortgage loans

How to qualify for an interest-only mortgage

Even if an interest-only mortgage seems right for your situation, it may not be a good fit due to the stricter lending requirements that often accompany these loan products. Lenders know that mortgage interest works differently with interest-only loans, so they consider them riskier for borrowers. You might be a good candidate if all of the following apply:

• You have a credit score of at least 680.
• You have the funds to make at least a 15% down payment.
• Your DTI ratio will be less than 40% in the second phase of your mortgage.
• You have proof of a financial cushion that can last six to 12 months.

Keeping these guidelines in mind, you may be able to improve your chances of getting approved by adding a co-borrower to the loan, taking some time to improve your credit score before applying, lowering your DTI by paying off debt and putting more in savings for a down payment or a financial cushion.

In addition to these special requirements, you’ll also need the standard documentation you would for any mortgage, including the following:

• Proof of stable income, usually for at least two years
• Proof of employment
• Proof of residence
• Two forms of photo ID
• Any other forms your specific lender requires