Interest-Only Mortgages: Compare the Pros and Cons
Interest-only mortgages aren’t as widely available as they were during the housing bubble.
But these mortgages aren’t completely extinct.
Some lenders continue to offer these programs.
An interest-only mortgage is a loan where you only make interest payments during the first several years of the loan term.
Once the interest-only period ends, you’ll pay both principal and interest. The interest-only period is typically five to 10 years.
But while still a mortgage option, these loans aren’t without risks.
Here’s a look at reasons to consider this type of loan, as well as a few reasons to avoid it.
What Are the Pros of an Interest-Only Mortgage?
The advantages of an interest-only mortgage loan include:
1. Qualify for a bigger mortgage
Interest-only mortgage loans are attractive because they result in a lower monthly payment.
Other home loans have higher payments because they include repayment of both interest and principal—starting from the beginning of the loan term.
When you’re only required to pay back interest, the monthly payment decreases.
One attractive aspect:
A lower monthly payment is an opportunity to get more house for your money.
You can buy a more expensive home, and possibly a bigger home while keeping your payment affordable.
2. Use the savings to hit other financial goals
Housing is likely one of your biggest monthly expenses. And depending on how much you pay for a mortgage, it can be difficult to reach other financial goals.
One benefit of only paying interest during the early years of a mortgage is that it frees up cash flow for other purposes.
An interest-only option can save hundreds of dollars each month. You can use this savings to invest, pay off other debt, or build a bigger emergency fund.
Let’s say you get a $200,000 mortgage at 4% interest. If you only make interest-only payments, you’ll pay about $666 a month, excluding homeowner’s insurance and taxes.
But if you start off repaying both principal and interest, your monthly payment increases to $955.
3. You can still build equity
Principal payments not only reduce the mortgage balance, but they also build equity.
But don't think that you can't build equity with interest-only payments.
Despite keeping your principal balance the same during these early years, you can still gain equity as your home value increases.
Let’s say your property value is $200,000 at the start of the interest-only mortgage term. If the property value jumps to $215,000 during the interest-only period, you would’ve gained $15,000 in equity without making a single principal payment.
What Are the Cons of an Interest-Only Mortgage?
The disadvantages of an interest-only mortgage include:
1. Your mortgage payment will increase
The downside to making interest-only payments:
Once repayment of principal starts, you can expect your monthly payment to increase.
And since many interest-only mortgages also have variable interest rates, your rate can also increase based on market conditions.
Between the possibility of a higher mortgage rate and repayment of principal, your mortgage payment could jump several hundred dollars per month.
This can lead to payment shock and cause significant financial hardship.
2. You might be unable to refinance
Some people agree to an interest-only mortgage with the intent of refinancing the property before repaying the principal.
Getting a 30-year fixed-rate mortgage can keep their payment affordable.
But while this is a practical solution in theory, you can’t predict the future.
Refinancing involves reapplying for a mortgage and getting approved by a lender.
And unfortunately, any changes to your income, employment status, or credit can make it harder to refinance.
If you can’t refinance, you’ll be stuck with a higher payment that you might be unable to afford.
3. You might be unable to sell the property
Not only can refinancing become difficult, selling the property could take longer than expected.
If you list your home for sale, there’s no guarantee that the property will sell before you start repaying the principal. Some properties sit on the real estate market for several months with little interest.
If the house takes longer to sell—or doesn’t sell—higher monthly payments could ruin your finances. Payment problems can put you at risk of foreclosure and damage your credit.
4. You’ll pay a higher interest rate
Interest-only mortgages remain a risky home loan product.
And the higher the mortgage risk, the higher a borrower’s mortgage rate.
So even though you’ll enjoy a lower payment—because you’re only paying back the interest— your mortgage rate will be higher than if you’d started off repaying both principal and interest.
5. You need good credit to qualify
When interest-only mortgages were popular in the mid-2000s, borrowers could get approved with lower credit scores and zero down.
Mortgage lenders have learned from this experience. Today, getting approved for an interest-only home loan requires a higher down payment and a higher credit score.
Specific requirements vary from lender to lender. Some banks require a minimum credit score of 700.
They also require a minimum 10 percent to 20 percent down payment to minimize their risk.
6. Risk of an upside-down mortgage
A higher down payment might not be enough to protect against declining home values.
If property values in your area decrease, lack of principal payments during the early part of your loan term increases the likelihood of having an upside-down mortgage. This is when you owe more than your home’s value.
Let’s say your home’s worth $200,000 and you bought with a $20,000 down payment. The larger down payment gives you instant equity, leaving a principal balance of $180,000.
But if your home’s value drops significantly, to say $175,000 by the end of the interest-only term, you’ll end up with negative equity.
The reality has become:
It'll be difficult to refinance or sell at this point.
You’ll have to make years of principal payments to dig yourself out of the hole.
Who Is the Best Candidate for an Interest-Only Mortgage?
An interest-only mortgage isn’t right for everyone.
Generally, these mortgages are better suited for people who expect their income to increase in the future. A higher income makes it easier to afford higher mortgage payments, in the event you’re unable to sell or refinance.
This mortgage might also work if you plan to live in a house for only five to 10 years.
With any mortgage, most of the early payments go toward repaying interest.
If you’ll only live in a property for a short time, it might make sense to get an interest-only mortgage and enjoy a lower payment. Just know that you’ll only earn equity if your property appreciates in value.
Also, interest-only mortgages are better for borrowers who have high credit scores and plenty of cash in reserves to afford the higher down payment.
Here are a few tips if you choose an interest-only mortgage:
1. Make extra principal payments
Whenever possible, make an extra principal payment toward your mortgage.
Even if you agree to interest-only, you can make an extra payment at anytime.
You might use a tax refund, work bonus, or other windfall. You can start chipping away at your principal balance and reduce the risk of negative equity.
2. Compare mortgage lenders
Today, interest-only mortgages are harder to find because they’re harder to sell on the secondary market.
Due to their higher risk, some banks refuse to offer these products.
Your best bet is to work with a portfolio lender. These lenders keep some of the mortgages they originate, so they can offer flexible mortgage solutions and set their own lending guidelines.
Since interest-only mortgages have higher rates, try and get quotes from at least three to four portfolio lenders to ensure the best deal.
3. Consider an adjustable-rate mortgage
An interest-only mortgage isn’t the only way to enjoy a lower payment in the early years of your home loan term.
Another option is an adjustable-rate mortgage. These loans typically start off with a low fixed rate for the first three to 10 years. The rate resets every year thereafter.
The initial rate is often lower than the rate on many fixed-rate loan products.
You’re able to enjoy a lower payment in the early years while repaying both principal and interest.
Interest-only mortgages can help you qualify for a bigger loan, reduce your monthly payments, and help you hit other financial goals.
But this mortgage solution isn’t without risks.
Weigh the pros and cons and then decide whether this is the right solution for your situation.