How do interest-only mortgages work?

Young couple touring their home, which they purchased with an interest-only mortgage.Image: Young couple touring their home, which they purchased with an interest-only mortgage.

In a Nutshell

With an interest-only mortgage, you’re paying only the interest on your loan — not any principal. You’ll have a lower monthly payment for a limited time, but you won’t build as much equity in the home until the interest-only period ends.
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With most mortgages, you make your payments each month and eventually pay off the entire loan. Interest-only mortgages are different.

When you take out an interest-only loan, you’re not paying down the principal balance you owe. Instead, you’re paying only the interest charges for a specified period of time.

This means you’ll have lower monthly payments at the start of the loan but could run into payment shock when the interest-only period ends. In this article, we’ll go over how an interest-only mortgage works, how it gets repaid and when you might consider an interest-only mortgage.



What is an interest-only mortgage and how does it work?

A traditional mortgage payment has two main components: principal and interest. The principal is the loan amount you borrowed. The interest is the money you pay the lender for allowing you to borrow.

With an interest-only mortgage, you pay only the interest on the loan for a set period of time, deferring your principal payment. During this period the principal balance remains unchanged.

Typically, an interest-only loan lasts for three to 10 years, and you pay a variable interest rate that changes periodically based on market conditions. When that time is up, you may have a few options.

  • Paying the loan balance all at once in a lump sum
  • Refinancing the mortgage
  • Starting to make principal and interest payments, which will be higher

This type of loan can include some risk. There’s no guarantee you’ll be able to refinance your loan or sell the home once the interest-only period ends.

Pros and cons of interest-only mortgages

Pros

  • Lower initial payments Because you’re paying only the interest for a set period of time, typically an interest-only mortgage initially features lower payments than a traditional mortgage.
  • Potentially lower interest rates Interest-only mortgages are typically offered as adjustable-rate loans. Adjustable-rate loans tend to have lower rates at first than fixed-rate loans, though the interest rate can rise over time.
  • Ability to buy a more expensive home Lower monthly mortgage payments mean you may be able to borrow more money and purchase a more expensive home. While this might sound appealing, you’ll want to make sure you can still afford payments once the interest-only period is up.

Cons

  • Potential payment shock Eventually you’ll need to make payments toward the principal, and when you do, your monthly obligation may be significantly higher. This increase could cause payment shock.
  • Limited equity — Since you’re not paying any principal during the interest-only period, you won’t build equity. Home equity is the difference between what you owe on your home loan and what your property is worth. It can be valuable to borrow against for future needs.
  • Higher interest rates in the future During the interest-only period, you may have an adjustable interest rate that goes up over time. Once the interest-only period ends, you may need to refinance your loan — and interest rates could be much higher in three to 10 years.
  • Home could lose value There’s no guarantee home prices will continue to rise. If the value of your home falls, you could find yourself under water on your mortgage — meaning you owe more than it’s worth — when the interest-only period ends. This can make it difficult to refinance.

Should I consider an interest-only mortgage?

At one time interest-only mortgages were more common — as common as nearly 1 in every 5 mortgages nationwide, and even higher in hot housing markets, according to the Federal Reserve Board of Chicago.

When the housing bubble burst, many families with interest-only mortgages defaulted on their loans and lost their homes. More recently, interest-only mortgages have made up less than 1% of the nation’s new home loans.

There are a limited number of circumstances in which an interest-only mortgage might work well for you.

  • You’re fairly certain you’ll make more money in the future. If you’re finishing up medical school, for example, or if you have a high-paying job lined up, it might make sense to take out an interest-only mortgage. You’ll have lower initial payments and will likely have the income you need to afford higher payments or qualify for a refinance loan when the time comes. But the risk is still there — your job could fall through or life could throw some other curveball that interrupts your plan.
  • You have irregular income. If your job is seasonal or commission-based, you may want the flexibility to make interest-only payments at first and make larger payments when you’re financially able. But you’ll still need to deal with the loan when the interest-only period is over.
  • You’re planning to move soon. If you sell the home before the interest-only period is over, you can avoid refinancing or making the higher payments. In this scenario, the risk is that if housing prices fall, you may wind up owing more than you can sell the house for.

Alternatives to interest-only mortgages

While the lower initial payments of an interest-only mortgage may be attractive, there are plenty of alternatives that might work better for you in the long term.

  • Fixed-rate mortgages — With these loans, your monthly principal and interest payment won’t change for the life of the loan, making them less risky. You can shop around and get quotes from different lenders to find the best fixed rate for your budget.
  • First-time homebuyer programs If you’re concerned about saving money to buy your first home, there may be state or local programs that can help. Many programs for prospective homeowners offer borrowers down payment assistance and relatively low fixed interest rates.
  • Saving up for a larger down payment — The more you can put down, the smaller your mortgage will be — and the lower your monthly payment will be.
  • Buying a less expensive home An interest-only mortgage might lure you into  buying a home that may be more costly than you can afford. A different type of mortgage, on the other hand, might help keep your spending more in line with the reality of your financial situation.

What’s next: Questions to ask before taking out an interest-only loan

If you think an interest-only loan would work well for you, make sure to dig deep into the terms before committing.

Here are questions to ask your lender about any offer you’re considering.

  • How will the interest rate work? Find out what your initial interest rate will be, when it will begin to adjust, how often it will adjust and what your maximum interest rate will be. Is there a cap?
  • When does the interest-only period end? You’ll want plenty of time to prepare to refinance, pay off the loan or make higher payments.
  • What will my payments be after the interest-only period? You’ll likely already know what your initial payment will be. If your loan will automatically convert to a principal and interest payment, find out what that payment would be at current market interest rates and at your interest rate maximum.
  • Is there a prepayment penalty? Some interest-only loans require you to pay a prepayment penalty if you pay off the mortgage early, which is often accomplished through refinancing.

About the author: Andrew Dunn is a veteran journalist with more than a decade of experience as a reporter and editor at North Carolina news organizations, including the Charlotte Observer and the StarNews in Wilmington. In those roles,… Read more.