What is an interest-only mortgage?

What is an interest-only mortgage?

This type of mortgage allows borrowers to pay only the interest on their loan — rather than the interest plus principal — for a set period of time. Typically, you’ll be given a term of five to 10 years where you essentially pay your lender only the cost of your loan.

If you want to make payments toward your principal balance, too, you can. But that’s not required during your interest-only term.

The interest-only payment structure offers you a lower monthly payment for the first few years of your loan. When the term is up, your payments will continue, but they will then be directed toward both the principal and interest.

More: Fixed-rate vs. adjustable-rate mortgages

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How does an interest-only mortgage work?

Most interest-only loans are adjustable-rate mortgages. For the set period of time where you strictly pay the interest on your loan, your rate will vary, meaning it will likely start out fairly low but typically go up every year. Once the interest-only term ends, the rate will almost certainly go even higher.

Once the responsibility of paying down your loan balance is folded into your monthly payments, you’ll find your payments suddenly become much more expensive.

Unless you made additional payments specifically on the principal over the years, at the end of your interest-only period your loan balance will be the same as it was the day the sale closed. Several years into your loan, you’ll owe the same amount — and have less time to pay down that principal.

But when the interest-only term is up, you can always refinance your loan or sell the home to pay off the balance.

Interest-only mortgage requirements

Depending on your financial standing, an interest-only mortgage may not be for you. The requirements for an interest-only mortgage tend to be a little tougher than with other types of loans.

You’ll likely need a higher of a credit score, more cash in the bank and a higher income than you would with a traditional 30-year fixed-rate mortgage.

However, there’s no set slate of qualifications for this loan, so they can vary fairly widely by lender. Regardless, you can expect to be held to a higher standard than traditional loan applicants.

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Who should get an interest-only mortgage?

If you’re low on cash in the short term, or if you have other financial obligations right now, this might be the right type of mortgage for you.

For those who work on commission, are self-employed or who expect their income to rise in the coming years, an interest-only mortgage offers a chance to direct your cash to the areas where you need it most right now.

Ideally, at the end of your interest-only period, you’ll be in a better financial position to manage the larger payments.

An interest-only mortgage also is a great option if you’re not planning to stay in the home for longer than your interest-only term. Once the term is up, you can sell the house, and hopefully pay off the entire principal (and keep a little extra if the home’s value has gone up, too).

Pros and cons

No doubt the idea of keeping your mortgage payments to the bare minimum is attractive. But there are some downsides and risks to going this route.

Pros of an interest-only mortgage

Besides the obvious benefit of lower monthly payments, you’ll also be able to claim up to 100% of your mortgage payments on your federal taxes. The IRS allows you to deduct the interest you pay on up to $750,000 in mortgage debt every year, provided the home is your primary residence.

If your loan balance is over $750,000, your write-off is capped, and you get no deduction on the interest paid on the mortgage amount above the threshold.

Cons of an interest-only mortgage

One major downside of not paying down the principal on your loan is that you aren’t helping to build equity in your home. Equity can build naturally, if a home’s value increases, but if the value doesn’t increase — or worse, it decreases — then you're going to find yourself saddled with a home that isn't even worth what you owe on it.

And while you may have a very affordable monthly payment for the first few years, it will very likely increase over time. And you can’t predict how it will increase because you’re at the mercy of the market.

Then, once your term expires, your interest rate (and your payments) may rise significantly. If you plan to stay in the home, you should expect your payments to jump.

Is an interest-only mortgage a good idea?

Ultimately, this isn’t a perfect option for all potential homeowners. While you stand to save a significant amount in the short term, there’s definitely some risk involved. This mortgage option is really for a select few who have a plan and lots of funds to see it through.

If your income is rising and you have plenty of money set aside, you can probably make an interest-only mortgage work in your favor.

But these home loans aren’t suitable for the average homebuyer, especially first-time homebuyers, who just want to pay the smallest possible amount every month.

More: What is a no-closing cost mortgage?

Is it easier to get an interest-only mortgage?

Definitely not. Generally, the credit score, debt-to-income ratio and cash reserve requirements lenders will want to see for this type of loan will disqualify most average households.

The best thing you can do with this type of mortgage is to make periodic principal payments to both lower the balance and build your home equity. If you have the type of job where you get large annual or semiannual bonuses, paying down your mortgage would be a smart use for those funds.

Interest-only loans have become far less common in recent years. They’re nonconforming loans, meaning the government-sponsored entities, Fannie Mae and Freddie Mac, won’t back them.

It might be more challenging to find a lender willing to offer you one of these loans. That’s why if you know this is the right type of mortgage for you, it’s so important to shop around for a few different rates from several lenders to ensure you get the best rate possible.

Getting the best mortgage

When you’re looking at your options for home loans, it’s good to be aware of all that’s out there. An interest-only mortgage only makes sense for a select few homebuyers.

For instance, a first-time homebuyer is likely to get a better deal with another type of mortgage.

Another great way to ensure you get the best possible rate on your loan is to get your free credit score and make sure your credit is in good standing.

Once you’re ready, with whatever loan type you decide to go with, you can apply for preapproval for a loan and start shopping for your new home.