What are interest-only mortgages and how do they work?

A home is the most expensive item many of us are likely to buy. For many homebuyers, the more costs they can cut in the near future without giving up the home they want, the better. That’s where an interest-only mortgage can help out.

These loans can significantly improve your monthly cash flow while getting you the mortgage you need. However, they also have several drawbacks, so you’ll need to weigh these thoroughly against the advantages before jumping in.

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.

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.

Still, you have the option of making principal payments of any amount during the interest-only period to reduce the balance — you just aren’t required to do so until the interest-only period ends.

Interest-only ARM

Most interest-only mortgages are structured as adjustable-rate mortgages (also called 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 later be adjusted each year.

Rates can change monthly, quarterly, yearly, or every three or five years.

When the fixed-rate period ends, the rate becomes variable — meaning it changes alongside a benchmark rate, such as the London Interbank Offered Rate (LIBOR).

Rates can change monthly, quarterly, yearly, every three years or every five years. However, ARMs generally come with a rate cap, meaning your rate will never exceed a specified amount. Once the interest-only period ends, your monthly payment is recalculated to accommodate the new interest rate and principal repayment over the remaining term.

That said, you can always make principal payments during the fixed-interest, interest-only period if you’d like.

Fixed-rate interest-only mortgage

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 principal now, and it’s amortized over a shorter term.

For instance, if you’re paying 4% APR on a $100,000 fixed loan with a 10-year interest-only period, your interest payment would be $333.33 for the interest-only period.

After that ends, your payment jumps to include principal and account for the shortened period to pay off that principal. If you had a 30-year mortgage, your monthly payment would be $606 for the remaining 20 years of your loan.

Interest-only mortgage pros and cons

The main advantage of interest-only mortgages is their low monthly payments in the first few years. This can keep your monthly cash flow positive and make a home more affordable at first.

Of course, you have to pay the principal eventually — and that’s the main drawback. Once the interest-only period ends, your payment increases significantly. This can be a huge financial shock if you haven’t budgeted accordingly.

You also face risks even during the interest-only period. For instance, you likely won’t build any equity during that time. Plus, if your home value declines while you’re only paying interest, you can end up upside down on your loan and owe more than your house is worth.

Bottom line: Is an interest-only mortgage worth it?

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 regular mortgage might be a better option if this is the case for you.