What are interest-only mortgages?

What is an interest-only mortgage?

An interest-only mortgage is a nonconforming mortgage loan that lets a borrower solely make interest payments — without paying any principal — for the first few years of the loan.

You can make principal payments of any amount during the interest-only period to reduce the balance.

As a result, your monthly payments on an interest-only mortgage start out lower than they might on a regular mortgage loan. Once the interest-only period ends, however, your monthly payment will increase substantially to account for the untouched principal amount.

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Interest-only ARM vs. fixed-rate interest-only mortgage

Most interest-only mortgages are structured as adjustable-rate mortgages (ARMs). These ARMs usually have a fixed interest rate for the interest-only period — likely as 3/1, 5/1, 7/1 or 10/1 loans, with the first number in each of these fractions representing the number of years you only pay interest and the rate remains fixed. The second number represents how often your rate will be adjusted.

Fixed-rate interest-only mortgages are fairly rare — they're even harder to find than interest-only ARMs. As the name implies, the interest rates on these never change. You pay no principal during the interest-only period if you don’t want to.

When that period ends, the lender amortizes the loan, which means they arrange your loan payments so you pay the same amount each month to eventually pay off the loan. Your payment will jump substantially at this time because you’re paying off the principal now, and it’s amortized over a shorter term.

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Interest-only mortgage pros and cons

“Mortgages are similar to a puzzle; you have to work out how all the pieces will fit together to meet each individual's needs and priorities,” said Sarah Alvarez, vice president of mortgage banking at William Raveis Mortgage.

“If you can make a larger down payment (typically at least 30%), an interest-only loan might be a good way to keep monthly payments low, knowing that you have a nice chunk of equity in the home.”

However, interest-only mortgages aren’t a good fit for everyone. Reviewer Susan from Florida was angry that one lender gave her 81-year-old father an interest-only mortgage, with an interest-only period of 10 years.

“Now that he is 91, his principal payments started and they are 3 times what he was paying. The mortgage alone is 62% of his total income,” she said.

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Bottom line

Interest-only mortgages may make sense for certain borrowers — generally, those with a high income or who are confident they will have a high income within a few years could benefit. For instance, a borrower with a high net worth may want to purchase a second home. They could opt for an interest-only loan to save money upfront — especially if they want to take advantage of low rates or cheap housing.

Maybe you’re a homebuyer running a rapidly growing business. An interest-only loan could help you save money to reinvest into your business for faster growth. You could also benefit if you don’t plan on settling into a home for long or are buying it for a short-term investment.

If you don’t fall into any of the above categories, you may not be able to experience the full benefits of interest-only loans — but you’ll still have to deal with the downside. A traditional mortgage might be a better option if this is the case for you.