What Are Interest-Only Mortgages And How Do They Work?
Lauren Bowling8-minute read
December 02, 2020
Interest rates are currently at historic lows, which is good news for consumers looking to finance a home. Today’s current low-rate environment may have you thinking about mortgage options in a different way, namely, getting a mortgage that enables you to pay the least amount in interest. While an interest-only mortgage may seem to fit the bill, there’s actually more to this financing option than meets the eye.
What Is An Interest-Only Mortgage?
Those with an interest-only mortgage only pay the interest on the loan for a set period of time, typically the first 5 – 10 years of the loan.
Interest-only mortgages come in two varieties: adjustable rate and fixed-rate. Fixed-rate interest-only options are rare. Usually, interest-only mortgages come baked into some type of adjustable rate structure. (More on this later.)
An important note: interest-only mortgages are a type of nonconforming mortgage, which means they’re hard to find and (usually) even harder to get. This is because only conforming mortgages can be insured, guaranteed and backed by Fannie Mae and Freddie Mac, which is why interest-only options aren’t widely available.
How Does An Interest-Only Mortgage Work?
For the first 5 or 10 years of the loan, an interest-only mortgage is fairly straightforward: the borrower pays only the interest due on the loan.
For example, you have a 30-year interest-only mortgage on a $300,000 home with an initial interest-only term of 5 years. At an interest rate of 3.5%, you’ll pay $875 each month during the interest-only term.
After the interest-only term expires, things get more expensive. In year six, the principal begins amortizing and the overall monthly payment on the loan increases substantially, because now you’re paying both interest and principal over a shorter length of time.
Take our $300,000 example above: after the first five years, the monthly payment escalates to $1,500 because you are now paying interest and principal amortized over 25 years instead of 30.
Adjustable Rate Interest-Only Mortgage Loan
For the sake of simplicity, the $300,000 example in the paragraph above assumes a fixed-rate interest only mortgage, but in reality, most interest-only loans are structured as adjustable rate mortgages (ARMs). Interest-only loans can be structured as a 3/1, 5/1, 7/1, or 10/1 – meaning the top number (3, 5, 7, 10) is the number of years you’d pay interest only.
The bottom number, (the “1”) is the number of times each year the mortgage rate gets adjusted. This means that once a year (and only once each year) the interest rate on your loan goes either up or down based on current rates. When determining interest rates, banks often look to benchmarks like LIBOR (and SOFR after 2021).
But don’t let the idea of an ARM freak you out. All ARMs come with rate caps, meaning your interest rate will never exceed a certain percentage. This keeps your interest rate from going up to a crazy amount, and while you can’t calculate your mortgage over time because you can’t predict rate changes, you can take out an adjustable rate mortgage knowing you won’t get completely gouged later on, because you’ll know the rate cap.
Fixed-Rate Interest-Only Mortgage
As stated before, fixed-rate interest-only mortgages are super rare, but they do exist. With interest rates as low as they are right now, a fixed-rate mortgage will almost always make more sense financially since you can lock in the low rate for the life of your mortgage. Rates likely won’t be lower than they are right now in our lifetime, which is why there is a lot of mortgage and refinance activity even with current economic uncertainty.
ARMs do tend to be more expensive after the initial rate term expires and here’s why.
- Using the $300,000 example at 3.5% interest rate, the monthly payment on a fixed-rate mortgage would be $875 during the interest only term of 5 years and then $1,500 after the interest-only period for the remaining 25 years on the mortgage.
- With an ARM, the introductory rate will be slightly lower than average in the beginning and a little bit higher upon amortization, say 3.2% to start and 3.7% afterward in year 6. This would make the monthly payment $800 during the intro period and roughly the same ($1534.24 monthly) afterward.
- The ARM would cost around $260,000 in interest (assuming a rate cap at 5%) and $203,000 in interest with the fixed rate.
Really, to get the full benefit of an interest-only mortgage, you’d need to either sell the house or refinance to a conventional mortgage before the interest-only term expires and the payment escalates to the higher rate.
Pros And Cons Of Interest-Only Loans
Interest-only loans exist because they do make financial sense for some borrowers. Many consumers find interest-only mortgage options appealing for one big reason: the ability to save money at the outset.
- Lower monthly payment during the introductory period
- Lower interest rates if structured as an adjustable rate mortgage
- The ability to keep more money “in cash” rather than locked up in home equity
- The ability to recoup cash spent on home purchase costs (closing costs, lender fees) faster
While the appeal of a lower monthly payment may be hard to resist, interest-only loans do come with a handful of disadvantages.
- The homeowner is not building up any equity unless they are making additional payments toward the principal
- The homeowner risks losing the equity created with the down payment if housing values decline, which could make it difficult to refinance
- Monthly payments will roughly double after the interest-only period
- Some interest-only mortgages may require a balloon, or lump sum, payment at the end of the loan term
Who Should Consider An Interest-Only Loan?
Lenders will generally make interest-only loans available to those who can demonstrate a high monthly income, a rising income and substantial cash savings in reserve. High net worth individuals may desire an interest-only mortgage because they feel their cash would be better served in a higher return investment vehicle rather than low-rate, low-volatility home equity.
Others Who Would Benefit From An Interest-Only Loan Include:
- Anyone with a short-term time horizon for owning the home (those who move frequently, are purchasing the home as a short-term investment, etc.)
- Those going through a divorce wherein one spouse needs to buy out the other and needs a low payment in the interim until they decide what to do with marital home
- Someone looking to buy a second home and then turn it into the primary residence later on (retirees)
Who Offers Interest-Only Mortgages?
Finding a lender to underwrite an interest-only mortgage is easier said than done. For those with a high monthly income, great credit and large cash savings, the best place to start looking is with your primary financial institution. If you do decide to explore options outside of where you do your day-to-day banking, be sure to only deal with a reputable lender. Before giving away your personally identifiable information, verify the lender on the Better Business Bureau website and read all online reviews.
Looking to start fresh? Check with your real estate agent or speak with the lender/mortgage broker who helped to finance any previous home purchases to see if they can recommend any lenders providing interest-only mortgages.
Interest-Only Mortgages FAQs
Why Do Lenders Prefer Conforming Loans?
A conforming loan is a mortgage loan that meets certain requirements by Fannie Mae and Freddie Mac. At this time, only conventional loans (loans not backed by any type of government agency) are conforming loans.
The reason why knowing the difference between conforming versus nonconforming is important is because of economics. Once a lender funds your loan, they typically sell it afterward to either Freddie Mac, Fannie Mae or other government sponsored enterprises.
These entities purchase mortgages to help increase the liquidity of the funding financial institution. This helps lenders get the mortgages “off the books” so they can then turn around and fund more mortgages. Nice, right?
There is a much smaller market for nonconforming loans, so issuing these loans limits the lender’s liquidity, but also often requires in-house servicing, which lenders prefer to avoid.
Are Nonconforming Loans Predatory?
The short answer is no. There are many types of nonconforming loans: VA, FHA and jumbo mortgages to name a few. Many borrowers only qualify for an FHA or jumbo mortgage, so these aren’t inherently predatory when offered by a reputable lender.
The reason nonconforming loans sometimes get major side-eye is because they don’t come with loan limits, while conforming loans do. (The current limit for a conforming loan is $548,250 in the contiguous United States.) Back in 2008 before the housing crash, lenders were underwriting loans of all sizes to borrowers who couldn’t afford them. Post-2008, the Consumer Financial Protect Bureau now has rules in place to help protect consumers from irresponsible mortgage lending practices and to ensure homeowners don’t borrow more than they can reasonably afford to repay in a lifetime.
Is It Harder To Qualify For A Interest-Only Loan?
Yes, it is harder to qualify for an interest-only loan. When you secure a loan from a lender, the home you’re purchasing is the “collateral” and the bank will foreclose on the home in the event you do not pay. They’re betting on the chance to build wealth with you and that you won’t walk away from any equity you’ve built and stop paying them back.
With an interest-only option, you’re only paying off the interest, so you don’t have any “skin in the game” so to speak. Because of this, lenders want to make doubly sure interest-only borrowers can definitely afford to make loan payments when the introductory period expires. Thus, interest-only loans are usually only afforded to those with ample means.
This isn’t interest-only specific though, as most reputable lenders require higher down payments and high credit scores when considering any type of nonconforming mortgage application.
The good news for those seriously considering an interest-only loan is that there are no regulatory limits but conforming and nonconforming mortgages must adhere to the CFPB’s best practices, including a low debt-to-income ratio.
Interest-Only Mortgages: An Option For Some
Interest-only mortgages may seem like a good idea to snag a lower monthly payment, but they’re actually a bit more complex than other mortgage options. Here’s what is most important to know when considering an interest-only mortgage:
- Most interest-only mortgages come as an ARM, with a set term (3 – 10 years) where the borrower pays only interest and zero principal on the loan.
- Interest-only mortgages can save money up front, but typically payments double after the introductory term expires.
- Only individuals with stellar credit and high liquidity qualify for an interest-only loan, but these loans are not predatory or “bad” for consumers.
Finally, it’s important to note that just because an interest-only loan comes with the interest-only payment period, borrowers can absolutely pay more than the interest should they opt to do so. Many enjoy this flexibility to pay above the interest to make additional debt progress and build equity. To learn more about buying a home, visit the Rocket Mortgage® Learning Center.
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