What Is an Interest-Only Mortgage, and Is It a Good Idea?
Interest rates have reached heights we haven’t seen in years, leading many to explore creative financing options. One alternative gaining traction in this climate is the interest-only mortgage.
But what is an interest-only mortgage? Interest-only mortgage loans are a financing option that allows borrowers to make interest-only payments for a set amount of time, typically seven to ten years. After the introductory period ends, borrowers must remit principal and interest payments for the remaining amount of the loan term at a variable rate.
Pursuing this financing option might be the key to making your homeownership dreams affordable. In this article, we’ll cover the ins and outs of interest-only mortgages, including how they work, the pros and cons, and how to qualify for this loan product.
Key Takeaways
Interest-only mortgages generate interest-only payments for a specified period, helping lower monthly payments.
Interest-only mortgage qualification criteria include a minimum credit score, a debt-to-income ratio below 43%, funds for a down payment, steady income streams, and other assets.
The risk of payment default due to higher interest rates is one of the main challenges of interest-only mortgages.
Interest-only mortgages might be a good idea if you expect to earn more income before the term expires, you can invest the difference to earn extra returns, or you only plan to hold the loan for a short period.
How Do Interest-Only Mortgages Work?
Interest-only mortgages defer principal repayment for a set amount of time, making your monthly payments more affordable. However, once the grace period is up, you must make both principal and interest payments, often at variable interest rates.
Some lenders might also require balloon payments with an interest-only mortgage. For example, you might be required to pay the entire principal balance off after the interest-only period is up. There are no standardized terms for interest-only mortgages, which is why it’s always best to shop around for the most favorable terms.
Interest-Only Mortgages: A Real-Life Example
Let’s say you want to take out a $350,000 mortgage with a 20% down payment. Your lender offers the option to make two years of interest-only payments at 6.0%. After the two-year grace period, your interest rate becomes variable for the remaining 28 years. Here’s how your payment is calculated for the first two years:
Monthly Interest Rate: 0.06 / 12 = 0.005%
Monthly Payment: ($350,000 - $70,000) * .005% = $1,400
Annual Interest Paid: $1,400 * 12 = $16,800
For the first two years, you would pay $1,400 per month. Now, let’s say interest rates increased after your two-year interest-only period. The variable rate is now 7.50%. Using a mortgage calculator, we find that our new monthly payment is $1,996.03. After the end of one full year of payments, here’s how your payment is allocated:
Remaining Principal: $280,000 - $3,056 = $276,944
Annual Interest Paid: $20,896
Total Interest Paid: $390,665.82
Remember that interest rates could also drop between the time you take out an interest-only mortgage and the expiration period. This would help reduce how much you pay in interest over the life of the loan.
Interest-Only Mortgage Balloon Payments
Interest-only mortgages can come with balloon payments. Keeping our initial factors the same as above, let’s explore this situation, assuming your lender requires a balloon payment that covers the remaining principal at the end of five years.
Annual Interest Payment: $1,400 * 12 = $16,800
Total Interest Paid: $16,800 * 5 = $84,000
As you can see, the total interest paid over the life of the loan is much lower than the interest-only mortgage. However, the balloon payment requires full repayment of the $280,000 at the end of five years. For many borrowers, coming up with this type of capital after five years is impossible.
Finding and Qualifying for an Interest-Only Mortgage
Interest-only mortgages are harder to find, partly due to the bad rep this loan product got in the 2008 Financial Crisis. In addition, interest-only mortgages create more risk for lenders. Although lenders receive monthly interest payments, there is a higher risk of borrower default when payments revert to normal levels. If you find a lender that offers interest-only mortgages, you must meet specific eligibility criteria. Here are some common qualification criteria:
Credit score of 700 or more
A debt-to-income ratio under 43%
20% or more down payment
Stable income with proof of future income
Other assets you own
It’s important to remember that each lender has different eligibility criteria. For example, some lenders will be more lenient on your debt-to-income ratio when you use a larger down payment. Nevertheless, lenders look for someone who can easily afford higher monthly payments after the interest-only period, has a stable income source, and has other assets in the event of a default.
Interest-Only Mortgages Are Risky
Interest-only mortgage payments might sound like a great idea, but it’s important to consider the risks. Let’s go back to 2008 and discuss how this loan product contributed to the financial crisis.
Many lenders offered borrowers interest-only mortgages to increase homeownership and close more loans. However, once the grace period ended, borrowers were unable to make their monthly payments, which included principal and interest. With high interest rates, borrowers began defaulting on their payments, resulting in the housing bubble bursting.
Before you take out an interest-only mortgage, it’s important to understand the affordability once regular payments start. Looking back to our initial example, the monthly payment increased from $1,750 to $2,447.25. These numbers also don’t include the rising costs of insurance and property taxes.
If you are struggling to afford the interest-only payment, you most likely won’t be able to afford the mortgage payment once the grace period ends, especially during times of rising interest rates.
Interest rates also pose another risk with interest-only mortgages. No one can predict the future market, meaning you have no idea where interest rates might be in a few years. As a result, there’s more security in locking in an interest rate for a 30-year term rather than hoping rates drop within the next few years.
When They Can Be a Good Idea
Despite the risks, interest-only mortgages can be advantageous in certain situations. For one, if you expect a higher income in the future, it might make sense to take advantage of an interest-only mortgage.
For example, your income might temporarily be lower if you are just graduating college. Over the next few years, you might expect to receive a significant pay raise. Additionally, if you sell or plan to refinance your loan before payments increase, you might be able to save some money with an interest-only mortgage.
Interest-only mortgage loans also have the ability to generate additional returns. For example, if your interest-only rate is 5% and the stock market returns an average of 10% each year, you can invest the difference between your interest-only payment and normal payment to generate more returns. This method also ensures you can afford the normal mortgage payment once the interest-only period expires.
Alternatives to Interest-Only Mortgages
If you’re seeking a lower monthly payment for the first few years of your mortgage, you have other options outside of an interest-only mortgage. For one, lenders offer adjustable-rate mortgages, known as ARMs, which provide a fixed interest rate for a specific period. After this timeframe expires, the rate becomes variable.
For example, you might be able to lock in a 5.00% interest rate for the first three years of your loan. After the first three years are up, your interest rate adjusts based on the prime rate each year. The biggest disadvantage of this method is the likelihood of your rate increasing after the initial term.
Additionally, if you are trying to lower your loan payments, some government-sponsored programs and grants might be able to help. These programs vary by state, so check with your local housing department for more information.
Refinancing an Interest-Only Mortgage
Taking out an interest-only mortgage doesn’t mean you are locked into the terms for the life of the loan. Instead, you can refinance your interest-only mortgage loan, whether into another interest-only mortgage or a conventional loan with a fixed interest rate. Refinancing requires you to go through the underwriting process again, similar to when you took out the initial mortgage.
Your lender will review your credit score, debt-to-income ratio, existing equity, and any additional down payment. If you don’t have enough equity in the home, you might be required to put more funds down to lower the lender’s risk. Remember, if you refinance out of an interest-only mortgage, expect your rate to be higher. Fixed rates provide more stability in your loan payment but are often higher than an interest-only rate.
Do Government-Backed Loan Programs Offer Interest-Only Mortgages?
No, government-backed loan programs do not offer interest-only mortgages. Interest-only mortgage loans are non-qualified mortgage loans, meaning they aren’t eligible for government-backed loan programs.
Our Take: Know the Risks
Interest-only mortgages sound great in theory, but they come with risks, such as higher monthly payments, that must be carefully evaluated. For most borrowers, the risks outweigh the benefits.
