Interest-Only Mortgage Pros and Cons

Pros of interest-only mortgages

One of the main reasons to get an interest-only mortgage is to have lower mortgage payments during the interest-only period. This can help free up cash flow and give homebuyers more flexibility with their monthly budgets.

Lower initial monthly payments

The main advantage of an interest-only mortgage is the period during which you only make interest payments that accrue each month. These payments are usually lower than what you’d pay monthly on a conventional mortgage.

These lower payments let you ease into mortgage payments and use that time to increase your income and even make home improvements before the interest-only period ends. Here’s a comparison of example monthly payments for an interest-only mortgage versus a conventional mortgage.

Helps home affordability

Because you’re only making interest payments, an interest-only mortgage can help you afford a more expensive home. If you’re confident that your household income will increase in the future — through salary increases or business growth — then this type of mortgage can be worth considering.

Interest-only mortgages can also help you afford a house when average home prices are high, but it’s time for you to buy your first home.

Rates could be lower

Because interest-only mortgage rates are usually tied to adjustable-rate mortgages, interest rates could be lower than conventional mortgage rates. That translates to lower monthly payments for you.

Plus, if your interest-only period ends while rates are lower than when you originated the loan, you could secure a lower rate for the rest of the mortgage.

Cons of interest-only mortgages

Interest-only mortgages, while potentially beneficial, have a few downsides that borrowers should carefully consider before applying.

You don’t build equity

While making interest-only payments on a mortgage, you aren’t chipping away at your principal balance, so you aren’t building more equity in your home. During the interest-only period, taking out a home equity loan or line of credit will be difficult, as you have no equity to borrow against.

If you put a large enough down payment on the house, you would have some equity, but likely not much. And if home values plummet, you could end up owing more on your mortgage than the house is worth, making you underwater on your mortgage.

Monthly payments increase

At the end of the interest-only period, you can expect your monthly payments to increase. You’ll pay for the interest that accrues on your principal balance, plus you’ll start paying for the principal balance itself.

As long as you planned for and anticipated this scenario, increased monthly payments may not be an issue. But if your income or budget didn’t increase and it’s time to start paying down the principal balance, you might find your home is too expensive to maintain payments.

Rates could increase

You’ll have your fixed interest rate for the first portion of the interest-only mortgage. But once the interest-only period ends, your mortgage converts to the second part of the loan, and rates could be higher. It’s smart to get an interest-only mortgage when rates are higher and you expect them to decrease in the next five to 10 years.

Interest-only mortgage vs. traditional mortgage

Interest-only mortgages have lower initial payments, but don’t build up any equity during the interest-only portion of the loan. When the interest-only period is over, the payment must begin to include interest and principal, which significantly raises the monthly payment. They are best for buyers who are looking at short-term ownership.

Traditional mortgages often have a fixed interest rate and stable monthly payments. You’ll pay a little more for the first few years, compared to an interest-only mortgage, but your payments remain the same for the life of the loan. You’ll also begin building equity right away. They are best for buyers who are looking to own the home long-term.

Who should and shouldn’t get an interest-only mortgage

Here are the types of borrowers who would benefit or lose from an interest-only mortgage. Carefully review your own financial situation and homebuying timeline to determine if this type of loan is right for you.

Who should get an interest-only mortgage

Well-qualified buyers, investors and borrowers buying their second home may benefit from interest-only mortgages. However, you’ll need to meet more strict borrower requirements to qualify.

Sarah DeFlorio of Williams Raveis Real Estate explained: “Typically, this product is reserved for the highest-tier borrowers with good credit, income and assets. In many cases, this type of financing will also require a larger down payment than its amortizing counterpart.”

You’ll generally need a credit score of at least 700 and a debt-to-income ratio below 36% to qualify for an interest-only mortgage. You’ll also need a large down payment and enough income to show you can repay the mortgage.

“People who are looking to keep monthly payments low and know that they will have the opportunity to pay down the principal using variable income, such as a bonus or investment distribution,” DeFlorio said. “Investors also use this type of loan to keep carrying costs low while holding a property.”

Who shouldn’t get an interest-only mortgage

First-time and less-qualified homebuyers shouldn’t get an interest-only mortgage; traditional mortgages would be better fits for their situations.

For first-time homebuyers, FHA and USDA loans provide looser borrower eligibility requirements that they’re more likely to meet and have lower down payment requirements. Even though interest-only mortgages have lower monthly payments, other loan programs can prove to have more long-term affordability.