What Is an Interest-Only Mortgage?

What Is an Interest-Only Mortgage?

An interest-only mortgage is structured in two phases:

• Initial phase: This period typically lasts three to 10 years, and you pay only interest on the loan principal.
• Amortization phase: The monthly payment amount increases, and payments go toward both interest and principal on the loan. This phase lasts for the rest of your mortgage term.

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How Do Interest-Only Mortgages Work?

Interest-only mortgages typically have adjustable interest rates so, after an initial rate-lock period with a set rate (typically three to 10 years), the interest resets regularly (as frequently as every six months), in sync with a posted market index or institutional interest rate.

Note that the lock period on the interest rate doesn't necessarily correspond with the interest-only period of the loan, so your monthly payments could be subject to change even during the interest-only phase of the loan term.

During the principal-plus-interest phase (also known as the amortization period) of an interest-free mortgage, payments are structured much like those in a traditional mortgage: A high percentage of the early payments go toward interest charges, and a relatively small fraction covers principal (and accumulates home equity). The balance gradually shifts over time so that by the end of the payment term, payments are mostly principal, and just a small portion goes toward interest.

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Interest-Only Mortgage Example

Here's an example illustrating how payments work on an interest-only mortgage. For the sake of clarity and simplicity, it ignores property taxes, insurance and other fees, and assumes the interest rate remains constant throughout the life of the loan.

Let's say you're financing a home with a market value of $450,000. After making a 20% down payment of $90,000, you'll be borrowing $360,000. You get a 30-year interest-only mortgage with a 10-year interest-only term and an annual interest rate of 7.5%.

Your initial monthly payment would be $2,250 (7.5% x $360,000).

Once the amortization period begins, your monthly payment would increase by nearly 30%, to $2,900.14. (Once again, this makes no allowance for market-related shifts in the loan's adjustable interest rate.)

Pros and Cons of Interest-Only Mortgages

Before you decide to take out an interest-only mortgage, there are some benefits and drawbacks to consider.

Pros of Interest-Only Mortgages

Potential advantages to interest-only mortgages include:

• Low initial payments: During the interest-only phase of an interest-only mortgage, monthly payments are typically lower than those on a comparable conventional mortgage and may mean you can get into a more expensive home than you could afford with a standard mortgage payment structure.
• Pay extra to lower payments: If your loan contract permits it (be sure to ask), you can apply extra payments on an interest-only mortgage against the loan principal, and that can lower the amount of your monthly payments.
• Opportunity to invest: During the loan's initial, lower-payment phase, you can use funds that would otherwise go toward principal payments on the loan for investments you expect to yield greater returns than what you'd pay in interest on the loan.
• Potential tax advantages: Mortgage interest of up to $750,000 per year is deductible on federal income taxes. Depending on your tax bracket, savings on your taxes during the initial phase of the repayment term could significantly offset the amount of your interest-only mortgage payments.

Cons of Interest-Only Mortgages

If you're considering an interest-only mortgage, you should be aware of these potential drawbacks:

• Higher total costs: Finance charges on mortgages are calculated by applying the interest rate against outstanding principal. With a conventional mortgage, you begin paying down principal on the loan with your very first payment, so monthly finance charges diminish over the life of the loan. Since there's no principal reduction until the amortization period begins, you end up paying more in interest over the life of the loan than you would with a conventional mortgage with the same repayment term.
• Deferred home equity: Unless you make extra payments that apply toward loan principal, you accumulate no home equity via payments during the interest-only portion of the loan term. As such, it can be difficult or impossible to get a home equity loan or line of credit on the property during that time.
• Lack of predictability: When an interest-only mortgage converts to an amortized payment structure, the size of the monthly payment increases significantly. That, combined with the fact that most interest-only mortgages are adjustable-rate mortgages, means it can be challenging to anticipate and budget for payments.
• Strict lending requirements: Lenders consider interest-only mortgages riskier than conventional loans, and therefore may insist on larger down payments and higher interest rates to offset the extra risk of issuing them. They also may require you to show that you have assets or investments to cover the loan amount.

How to Qualify for an Interest-Only Mortgage

Interest-only mortgages are relatively uncommon, so begin by identifying lenders in your area that offer them. A mortgage broker or other real estate professional may be able to help with this.

Qualification requirements vary by lender, but they may include:

• A strong credit score (FICO^® Score^☉ of 680 or better)
• A low debt-to-income ratio
• A down payment of at least 15%, often higher

The lender may scrutinize your finances even more thoroughly for an interest-only mortgage than they would when issuing a conventional mortgage. They may require you to document savings or assets that you can tap if needed to cover payments during the amortization period.

Should I Consider an Interest-Only Mortgage?

Interest-only mortgages aren't for everyone, but they may be worth considering if you meet eligibility criteria also fall into one or more of these circumstances:

• You have reliable expectations of major income growth in the foreseeable future (for example, if you are a recent graduate of law school or medical school).
• You have significant assets (real estate, investment securities or similar) you can liquidate if necessary to pay off the loan.
• You plan to re-sell the house before the loan's amortization period begins (for example, because you anticipate relocating within a short time, or wish to "flip" the property after performing renovations). A market downturn or other economic issues could thwart such plans.
• You are approaching retirement age and will gain penalty-free access to tax-advantaged funds such as individual retirement accounts (IRAs) or 401(k) accounts in time to cover the payment increases in the loan's amortization period.

Alternatives to Interest-Only Mortgages

Here are some other options to consider when pondering an interest-only mortgage:

• Conventional loan: If you're wary of the unpredictability of an interest-only mortgage, or if you don't meet its steep eligibility requirements, a conventional mortgage loan might make more sense for you. The relatively higher initial payments may mean you'll have to consider a less expensive home than you'd prefer, but you'll trade that for predictable payments and accrued home equity.
• Jumbo loan: If you want to finance a home that's significantly more expensive than the average homes in your county, a jumbo loan may be your only option. Jumbo loans are most commonly offered as standard-repayment mortgages, but they are also available as interest-only mortgages. Lenders associate jumbo loans with relatively high risk, and they come with many of the same strict lending requirements as interest-only mortgages.

The Bottom Line

If an interest-only mortgage fits your needs, you'll want to do all you can to ensure you qualify. Checking your FICO^® Score for free from Experian is a good place to start. If your score is lower than you'd hope, consider taking steps to build your credit in preparation for a mortgage. When you're ready to apply for the loan, shop carefully and get quotes from multiple lenders to find the best loan terms you can get.