What is an Interest-Only Loan?

An interest-only mortgage allows you to pay only the interest for the initial years of the loan, which lowers your monthly payments at the start. While this may seem like an appealing way to save on mortgage costs, it’s essential to understand how these loans work before committing.

One key point to remember is that once the interest-only period ends, you’ll begin paying both interest and the principal amount. Although you can choose to make principal payments during the interest-only period, they become mandatory once this phase concludes, and the time left to repay the principal is shorter than the total loan term.

How an Interest-Only Mortgage Works

Most interest-only mortgages are adjustable-rate mortgages (ARMs), where you pay only the interest for up to 10 years. After this period, you start repaying both principal and interest. The adjustable rate means your payments could increase or decrease over the loan’s life, depending on rate changes.

For example, if you take out a $100,000 interest-only ARM at 5% interest with a 10-year interest-only period, your monthly payments would be around $417 for the first 10 years, covering just the interest. Once this period ends, your payments will rise significantly as both the principal and interest payments kick in. Additionally, if the loan is an ARM, your payment could fluctuate due to changes in the interest rate.

Why Consider an Interest-Only Mortgage?

If your goal is to keep monthly housing costs low, an interest-only mortgage might be a good fit. This type of loan is often suitable for people who don’t plan to stay in the home long-term, such as frequent movers or short-term investors.

Interest-only mortgages are also popular among second-home buyers, particularly those who plan to convert the second home into their primary residence in the future. During the interest-only period, payments are more manageable, especially if you’re not yet living in the home full-time.

While this loan type may offer lower payments, approval is typically more difficult, requiring high credit scores, significant savings, and a low debt-to-income ratio.

Pros of an Interest-Only Mortgage

Interest-only loans offer several potential benefits:

• Lower initial monthly payments: Since you’re only paying interest during the early years, your payments are lower compared to conventional loans.
• May allow you to afford a more expensive home: The reduced payments during the interest-only period can enable you to qualify for a larger loan.
• Faster payoff potential: By making extra payments during the interest-only period, you can reduce the principal, lowering future payments.
• Increased cash flow: The lower monthly payments may free up funds for other expenses.
• Potentially lower interest rates: These loans are usually structured as adjustable-rate mortgages, which often have lower initial rates compared to fixed-rate loans.

Cons of an Interest-Only Mortgage

However, there are risks associated with interest-only loans:

• No equity building: You won’t start building equity in your home until you begin paying down the principal.
• Potential equity loss: If your home’s value decreases, you could lose any equity gained from your down payment, making refinancing more difficult.
• Temporary low payments: While the initial payments are low, they won’t last forever. Once the interest-only period ends, your payments will rise significantly.
• Rising interest rates: Since most interest-only loans have variable rates, your payments could increase if interest rates go up.

An interest-only mortgage can offer lower monthly payments and flexibility for short-term homeowners or investors. However, it’s important to understand that principal payments are unavoidable down the line. Carefully weigh the pros and cons before deciding if this loan type is right for you.