Interest only mortgages

Table of Contents

What is an interest-only loan?

How does an interest-only mortgage work in practice?

Interest-only loans vs. other mortgage rates

Are interest-only loans adjustable-rate mortgages?

Fixed-rate interest-only loan options

Who should consider an interest-only mortgage?

Who should NOT consider an interest-only loan?

Interest-only mortgage advantages

Interest-only mortgage disadvantages

How to find the best interest-only mortgage rate today

Interest-only mortgages vs. other mortgage types

Get the right loan and the right rate for your budget

What is an interest-only loan?

In the simplest terms, an interest-only mortgage requires the borrower to make payments solely on the interest due on the loan monthly rather than both the interest and the principal — at least at first. This arrangement lasts for a set amount of time — say, 5 years — before adding the principal back into the equation. Essentially, you’re delaying repayment on the principal itself and reducing your monthly mortgage payments in the short term. That also means, however, that you’ll wind up spending more on housing costs once the interest-only period comes to an end.

Compare that with a conventional mortgage, which combines the principal and interest in your monthly payments from Day One. If you take a standard 30-year fixed-rate mortgage, for instance, your monthly mortgage installments will remain the same across the entire life of the home loan.

Because you’re pushing back the principal repayment for several years when you use an interest-only mortgage, your mortgage payments will be lower at the outset. But, that also means your monthly payments will increase later on once you start repaying the principal. So, there’s a pretty significant tradeoff to consider.

How does an interest-only mortgage work in practice?

Before we go any further, it’s important to stress that interest-only loans are considered non-qualified mortgages. That means you cannot use them with conventional conforming loans, FHA loans or VA loans, except in very rare cases. In most situations, lenders may limit interest-only options to jumbo loans rather than more conventional loan types.

Let’s say you take out a 30-year interest-only mortgage with an initial 5-year interest-only period. Your principal payments would be amortized over the remaining 25 years of the loan term, rather than all 30 years. In essence, you’re pushing the bulk of your mortgage payments to the back end of the deal.

Looking for an interest-only mortgage calculator? To figure out your interest-only payments, simply follow this formula:

LA * IR / 12 = ITMP

• LA: Loan amount
• IR: Interest rate
• ITMP: Initial-term monthly payment

It doesn’t matter how long the interest-only payment period is; the amount you owe each month during that time will always stay the same. Figuring out your payments for the remainder of the home loan is a bit more complicated, though. That’s because the length of the initial term impacts how much you owe on the back end.

How big of a difference are we talking here? Here’s what your monthly installments might look like with a $200,000 mortgage, a 3.25% interest rate and a 5-year interest-only payment term:

• First 60 months (interest only): $541.67
• Last 300 months (interest + principal): $974.63*

Now here’s that same interest-only mortgage with a 10-year initial term:

• First 120 months (interest only): $541.67
• Last 240 months (interest + principal): $1,134.39**

As you can see, you pay the same amount over a longer term with the second example. Once that initial term ends, though, your payments would increase for the next portion of your home loan.

Keep in mind that these figures don’t take into account other housing costs like homeowners insurance, property taxes and homeowner’s association fees. But those expenses aren’t impacted by interest-only mortgages, one way or the other. Whether you’re interested in an interest-only mortgage or a conventional home loan, our mortgage payment calculator is a good place to start planning how much you’ll spend each month on housing.

Interest-only loan rates vs. other mortgage rates

So, how do the interest rates on interest-only loans compare with other types of mortgages? You may have noticed that interest-only mortgages are pretty similar to adjustable rate mortgages (ARM), at least in terms of their structure. Given that, it shouldn’t come as a surprise that interest rates for both mortgage types are similar as well.

Even assuming you get a lower rate, you’ll most likely pay more interest over the course of the loan due to the way interest-only mortgages are structured. No matter which way you may be leaning, be sure to look at the current mortgage rates to make an informed decision.

Are interest-only loans adjustable-rate mortgages?

Interest-only mortgages are often structured similarly to ARM home loans. Your interest rate is locked in for the initial payment term, whether that’s 5, 10 or 15 years. After that, your mortgage rate may be reset based on market trends, the state of the economy, treasury bond performance and other ARM terms.

So far, we’ve basically described how an ARM works. The big differences between an interest-only mortgage and, say, a 10-year ARM are usually the underwriting restrictions and loan amount. Interest-only loan products are geared toward high-income borrowers — people who have the funds and financial history to qualify for a much larger sum of money.

Fixed-rate interest-only loan options

Although interest-only mortgages are usually offered on Adjustable Rate Mortgages, you may come across a lender offering fixed-rate options. What’s the difference? With a fixed-rate interest-only loan, your mortgage rate stays the same from start to finish. That’s not the case with an adjustable-rate interest-only mortgage, where your rate may change after the interest-only period ends.

If given the option between the two, you should think long and hard about the potential pros and cons of both before making a decision. Think mortgage rates will go up over the next several years? You might be better off locking in a fixed rate now than rolling the dice on an adjustable rate. On the other hand, you could wind up paying more if interest rates nose dive during the life of your home loan.

Who should consider an interest-only mortgage?

Interest-only mortgages can be pretty enticing given the low upfront monthly payments. But when does it make the most sense for homebuyers to choose these home loans over more conventional options? Here are a few scenarios to consider:

• Your main concern is to lower your monthly mortgage payments as much as possible over the next 5 or 10 years.
• While building equity in your home would be nice, it’s not your biggest motivator compared with reducing your housing costs.
• You’re more interested in putting your money toward investment vehicles like stocks and bonds.
• You own multiple investment properties, renting them out to generate extra income, and intend to only hold onto them for a few years before flipping them.
• Money is tight right now, but you believe your career trajectory is pointing upward and you expect a much higher income later down the road.
• You don’t want to wait any longer to move into your dream house and you can afford to take out a jumbo loan.
• You want to free up money in case you need to make repairs or renovations to your new home.

In each of those cases, the appeal of lower monthly payments over an initial term period may outweigh any concerns about dealing with higher housing costs on the back end of the mortgage.

Who should NOT consider an interest-only loan?

In the right circumstances, interest-only mortgages can be hugely beneficial, but they don’t always present the best path to homeownership. If any of these situations sound familiar, you may be better off looking at other types of home loans:

• Your income isn’t likely to grow much over the next 10-20 years.
• You’re nervous about paying higher rates once the initial term period ends. Exercising some healthy caution is one thing, but if you’re genuinely worried you won’t be able to afford your monthly payments later on, this probably isn’t the right financing for you.
• You want to build equity in your new home as quickly as possible.
• You’d like to keep your options open to refinance your mortgage in a few years and potentially take advantage of lower interest rates.
• You’re concerned housing prices in your real estate market will drop significantly in the coming years, possibly putting you underwater on your interest-only loan.

When weighing your options, you need to be aware that an interest-only loan presents some additional risk compared with a conventional fixed-rate mortgage. You’re assuming you’ll have more money to throw at your mortgage later on, but there are no guarantees in life.

Interest-only mortgage advantages

Despite the potential risk that an interest-only home loan presents, there’s an undeniable appeal to these types of mortgages. In some cases, the benefits of an interest-only mortgage are too tempting to pass up. Those advantages include:

• Lower monthly payments for the first several years of your loan
• More financial flexibility during the initial loan term
• Increased potential to buy a more expensive home, assuming you meet the more restrictive underwriting requirements and qualify for an interest-only loan.

Is that enough incentive to overlook some of the tradeoffs with this type of loan? It really depends on your needs, risk threshold and specific circumstances.

Interest-only mortgage disadvantages

Many people look at interest-only loans as an opportunity to get more bang for their buck, stretching their housing budget and buying houses that might otherwise be outside of their reach. Keep in mind that you’ll face more restrictive underwriting requirements — such as making a much bigger down payment — to mitigate the risk attached to these loans. There are pretty significant drawbacks to consider, as well, so be sure to look over each of these disadvantages with interest-only mortgages:

• You’ll see higher mortgage rates for the bulk of the mortgage term.
• You won’t be able to build equity in the home until later in the life of the loan.
• You’ll take on more risk of defaulting on your mortgage if your financial situation doesn’t improve by the end of the initial payment period.
• You may have trouble selling the house down the road if housing prices drop and you haven’t built up sufficient equity yet.
• You may wind up with negative amortization, potentially resulting in a mortgage that’s higher than the actual value of your home.

You need to carefully consider the pros and cons of interest-only mortgages before agreeing to a home loan. After reviewing your financial records, a qualified loan officer should be able to give you sound advice on the best way to proceed, based on your current situation and long-term outlook. That’s why it’s so important to work with a mortgage lender you trust to steer you in the right direction.

How to find the best interest-only mortgage rate today

Comparing interest rates is a hugely important step in the homebuying journey — especially if you want to get the best terms possible on your mortgage. It’s always a good idea to shop around so you can find the best interest-only mortgage rates today. If you’re looking for a longer initial payment period — say, 10 years, instead of 5 — keep in mind that you’ll end up paying more interest over the life of the loan. Speak with a knowledgeable loan officer who’s able to walk you through different loan options and help you weigh the pros and cons of each one.

Not all lenders offer this type of home loan, in part because there’s less demand for them on the secondary mortgage market. Don’t be surprised if you have fewer options to choose from when looking for interest-only mortgage lenders.

Interest-only mortgages vs. other mortgage types

Homebuyers have tons of financing options to choose from beyond interest-only mortgages. Take the time to research each type of home loan*** you might qualify for to see which one suits you best:

• 30-year fixed-rate conforming mortgage: This type of home loan has become the industry standard, and for good reason. The fixed rate means your monthly payments are consistent across the entire life of the loan, while the 30-year period keeps your ongoing housing costs down to a manageable level.
• 15-year fixed-rate conforming mortgage: If you want to grab a bigger stake of your home’s equity as quickly as possible — without making a larger down payment, that is — a 15-year mortgage could be the financing vehicle you need. It functions the same way as a 30-year fixed-rate home loan, just in half the time.
• 10-year ARM conforming mortgage: Gaining popularity, a 10-year ARM holds a fixed rate for the first 10 years of the loan before increasing or decreasing.
• 7-year ARM conforming mortgage: An ARM might be the way to go if you want to strike a balance between the lower payments of an interest-only loan and the equity-building potential of a conventional fixed-rate mortgage.
• 5-year ARM conforming mortgage: Similar to a 7-year ARM, this type of mortgage offers an introductory interest rate over the first 5 years of the home loan before requiring a refinance.
• FHA conforming mortgage: Low funds or a non-existent credit history shouldn’t stand in your way of buying a home. This government-insured loan makes it easier for people with low to moderate income to secure a mortgage and realize their dreams of becoming a homeowner.
• VA conforming mortgage: Active and retired service members can take advantage of VA mortgages to secure financing for a new home — often without needing to make a down payment.
• Jumbo mortgage: Have your sights set on a more luxurious home in a high-cost market? Jumbo mortgages help homebuyers finance larger transactions so you can purchase that magnificent dream house.

Get the right loan and the right rate for your budget

An interest-only mortgage can be a great way to lower your monthly housing costs for a short period of time and enjoy more financial flexibility during the early days of homeownership. But interest-only loans are, at their core, lending products designed for high-income borrowers. That includes homebuyers with the financial status to meet more restrictive underwriting requirements and qualify for a jumbo loan. As such, it’s not the best solution for every situation, especially if you want to start building equity right away.

The truth is, there is no such thing as a single, all-purpose home loan that’s right for every homebuyer. Everyone enters the mortgage process with their own unique circumstances and needs that need to be met. With that in mind, it’s always a good idea to work with expert loan officers who understand the nuts and bolts of these financing tools better than just about anyone.

Ready to take the next step toward buying a new home? Get a personalized rate from one of our qualified loan officers today.

Disclaimers

*Example scenario provided for illustrative purposes only. Based on an annual percentage rate (APR), and 60 payments of $541.67 and 300 payments of $974.63. Advertised rates and APR effective as of 5/17/21 and are subject to change without notice.

**Example scenario provided for illustrative purposes only. Based on an annual percentage rate (APR), and 120 payments of $541.67 and 240 payments of $1,134.39. Advertised rates and APR effective as of 5/17/21 and are subject to change without notice.

***To understand the terms of repayment and review representative examples, please review information here.