What Is An Interest-Only Mortgage?

The process of focusing on paying interest first while paying down debt over time is called “amortization.” You’ll usually see interest-only loans structured as 3/1, 5/1, 7/1, or 10/1 adjustable-rate mortgages (ARMs). Generally, the interest-only period is equal to the fixed-rate period for adjustable-rate loans. That means if you have a 10/1 ARM, for instance, you would pay interest only for the first 10 years. Your monthly payment will be lower than a comparable conventional mortgage for the first several years of repayment.

But others might accept alternative means, like bank statements or proof of other assets. Repayment periodWhen the initial period ends, the loan will convert to an amortization schedule. You’ll make larger payments that go toward both the principal and interest for the remainder of the loan term. Even though you’re only required to pay the interest at first, you still have the option of paying down the principal during the loan’s introductory period. This was one of the risky practices that contributed to the housing crisis in 2007, leading to the Great Recession. After the interest-only period, you must start paying five types of budgets in managerial accounting both principal and interest, resulting in higher payments.

With both the traditional fixed-rate option and our interest-only loan example, you’d pay a total of about $677,000, with around $347,000 of those payments going toward interest. As you can see, however, you’d ultimately have a higher monthly payment with an interest-only loan. If your interest-only loan requires a balloon payment instead, you’d be on the hook for several hundred thousand dollars. While your payments may change once you start paying toward your principal balance, the rate of interest you’re paying will never fluctuate for as long as you have the loan. Interest-only payments may be made for a specified time period, may be given as an option, or may last throughout the duration of the loan.

1. Interest-only loans work well when you use them as part of a sound financial strategy, but they can cause you long-term financial trouble if you use interest-only payments to buy more than you can afford.
2. These can give you more affordable payments without the future jump that comes with an interest-only mortgage.
3. This could be a problem if it coincides with a downturn in one’s finances—loss of a job, an unexpected medical emergency, etc.
4. These payments of principal and interest are going to be larger than the interest-only ones.

Down payment and equity

Lifetime caps are almost always 5% above the loan’s starting interest rate, Fleming says. So if your starting rate is 3%, it might increase to 5% in year eight, 7% in year nine, and max out at 8% in year 10. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent, a Motley Fool service, does not cover all offers on the market. Interest-only mortgages have more risk for lenders since you won’t reduce your loan balance for many years.

Eventually, you’re required to pay off the full loan either as a lump sum or with higher monthly payments that include principal and interest. With most loans, your monthly payments go toward both your interest costs and your loan balance. Over time, you keep up with interest charges and gradually eliminate the debt owed. After a set period of time — usually between three and 10 years — your interest-only period ends. Your loan payments are then recalculated and you’ll start paying both principal and interest. The result is a higher monthly payment for the rest of your loan term.

Interest-only mortgage example

Hybrid loans can come with lower rates than fixed-rate loans, yet still have a fixed rate for the initial term. In some cases, they can provide a lower monthly payment than a 30-year fixed-rate, fully amortized loan for those initial years — typically five, seven or 10 years. You may think that a mortgage with lower initial monthly payments would be easier to qualify for, but that’s not necessarily true.

Who Qualifies for an Interest-Only Mortgage?

Then you’ll have to pay principal plus interest, so your monthly payment will increase. Interest-only mortgages can be either fixed-rate or adjustable-rate loans. That said, because interest-only loans are non-QM, they can use a wider variety of means to demonstrate your ability to taxable income repay. Some lenders may use traditional methods — like pay stubs or tax documents — to calculate your income.

For this reason, interest-only loans don’t qualify for government-backed programs, like FHA, VA or USDA loans. With a 30-year fixed-rate mortgage for the same amount, you’d pay $1,882 per month. This includes principal and interest, and also accounts for the higher rate on this type of loan — in this case, 5.54 percent. After this initial phase, with our interest-only loan example, the payment would rise to $2,033 per month — assuming your rate doesn’t change. Many interest-only loans convert to an adjustable rate, so if rates rise in the future, yours will, too (and vice versa).

The housing market may decline, for example, or your home might lose value for some other reason. Because of this, getting an interest-only mortgage with plans to sell before the interest-only period ends is risky. Not only will you not build equity during the interest-only period, but you could actually lose equity due to changing market conditions. Your payments will also increase once your interest-only period expires. This information may include links or references to third-party resources or content.

A preapproval is based on a review of income and asset information you provide, your credit report and an automated underwriting system review. The issuance of a preapproval letter is not a loan commitment or a guarantee for loan approval. Preapprovals are not available on all products and may expire after 90 days.

Some borrowers may choose to refinance their loan after the interest-only term has expired, which can provide for new terms and potentially lower interest payments with the principal. Other borrowers may choose to sell the home they mortgaged to pay off the loan. Still, other borrowers may opt to make a one-time lump sum payment when the loan is due—having saved up by not paying the principal all those years. An interest-only mortgage’s interest rate is the final key piece of the puzzle. Most interest-only mortgages are adjustable-rate mortgages (ARMs), which means your interest rate will adjust over time with the market.

The interest rates are comparable with what you might find with a conventional loan, but because you’re not paying any principal, the initial payments are much lower. However, they may still include property taxes, homeowners insurance and possibly private mortgage insurance (PMI). Interest-only mortgages reduce the required monthly payment for a mortgage borrower by excluding the principal portion from a payment. Homebuyers have the advantage of increased cash flow and greater support for managing monthly expenses. For first-time home buyers, an interest-only mortgage also allows them to defer large payments into future years when they expect their income to be higher.

The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters. Before you refinance a mortgage, know the key mortgage refinance requirements for major loan types. The table below shows how much you might pay in interest if you took out a $300,000 home loan with a 10-year interest-only period, versus a traditional, fully amortizing mortgage. There are two different periods that make up the borrowing term for an interest-only mortgage loan.

Requirements vary, but even the best mortgage lenders typically require good or excellent credit. Most also require a larger down payment than you’d need for a traditional mortgage. Borrowers who live in designated rural areas may qualify for a USDA loan backed by the U.S. Department of Agriculture (USDA) to buy, build or improve a house. You’ll typically need at least a 640 credit score to qualify, though each lender is free to set their own minimum. To find out whether the home or area you’re interested in is eligible, use the USDA loan map.