What are interest-only mortgages?

You can avoid paying principal upfront, but there are drawbacks

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No matter which type of mortgage loan you choose, buying a home is expensive. One way buyers can enhance their short-term cash flow while securing a mortgage is to use an interest-only mortgage. An interest-only mortgage is a type of loan that lets you pay only the interest on the mortgage for a specific period.

While this option might seem handy, there are some drawbacks that could impact your long-term financial plan.


Key insights

  • Interest-only mortgages can provide significant short-term cash flow benefits in the beginning of your loan term.
  • The principal amount of your loan remains unchanged during the interest-only period, resulting in higher payments in the future.
  • Interest-only mortgages are ideal for buyers looking to sell their property in a short time rather than those seeking long-time homeownership.

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.

» MORE: Mortgage closing costs vs. prepaids: What’s the difference?

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.

» MORE: How to lower your monthly mortgage payment

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.

Pros

  • Initial savings: Your monthly payments will be lower during your interest-only period.
  • More cash flow: You may have more cash available for other expenses or investments.
  • Home affordability: These loans can potentially allow you to afford a pricier home than you could with a traditional mortgage
  • Flexibility: You can initially pay toward the principal if you want to.

Cons

  • Equity building: Interest-only loans do not build home equity during the interest-only period since you aren’t paying principal.
  • Higher long-term cost: Despite the lower initial payments, interest-only loans can end up costing more over time.
  • Increased payment: Once the interest-only period ends, monthly payments will significantly increase.
  • Interest rate increase: If you have an interest-only ARM, rising interest rates can also increase your payments.

» MORE: 13 first-time homebuyer mistakes and how to avoid them

View rates from leading lenders now.

    FAQ

    Who might benefit from an interest-only mortgage?

    Interest-only mortgages can be beneficial for individuals with irregular income streams, those expecting a significant rise in income in the future or investors or home flippers who plan to sell the property within the interest-only period.

    Can I switch from an interest-only mortgage to a traditional mortgage?

    Yes, you can refinance your interest-only mortgage to a traditional mortgage. You will need to meet lender qualifications and might end up with a higher interest rate than when you first purchased your home.

    How do you calculate interest-only mortgage payments?

    To calculate your interest-only mortgage payments, you’ll first convert your APR percentage to a decimal by dividing it by 100. Then, divide the result by 12 for the 12 months in a year. After that, you’ll multiply the result by your total loan balance to arrive at your monthly interest-only payment.

    Here's how you would calculate your interest-only payments if you take out a $100,000 interest-only loan at 4% APR:
    4 / 100 = 0.04
    0.04 / 12 = 0.0033333 (repeating)
    0.0033333 x 100,000 = $333.33

    Your interest-only payment would be $333.33 per month. This number should be stable through the fixed-rate, interest-only period of your mortgage, but you’ll pay more once you have to start paying off your principal.

    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.


    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. The Federal Reserve Board, “ Consumer Handbook on Adjustable-Rate Mortgages .” Accessed Aug. 24, 2023.
    2. IRS, “ Publication 936 (2022), Home Mortgage Interest Deduction .” Accessed Aug. 24, 2023.
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