An interest-only mortgage is a loan with monthly payments only on the interest of the amount borrowed for an initial term at a fixed interest rate. The interest-only period typically lasts for 7 - 10 years and the total loan term is 30 years. After the initial phase is over, an interest-only loan begins amortizing and you start paying the principal and interest for the remainder of the loan term at an adjustable interest rate.
Using an interest-only mortgage payment calculator shows what your monthly mortgage payment would be by taking factoring in your interest-only loan term, interest rate and loan amount. The result is your estimated interest-only mortgage payment for the interest-only period and doesn’t account for the principal payments you’ll make later when the loan beings amortizing.
Mark Klein, founder & CEO at PCL Financial Group, a mortgage firm in Southern California, is a fan of interest-only mortgages for certain clients. “They're really good for people who have variable income,” he explains. “It can be beneficial when your cash flow is short, or when you need your money for other reasons.” This may apply to those who are in commission-based businesses, are self-employed or are leveraging their liquid cash for other investments.
Many of Klein’s clients are purchasing homes that are designated as jumbo mortgages, meaning loans that exceed the limits set by government-sponsored mortgages like the FHA mortgage. “For those higher loan amounts, we do interest-only because it's more of a financial planning tool for how they're going to use their cash flow.” Those clients may want to explore the interest-only mortgage calculator.
Interest-only loans can also be good for people who have a rising income, significant cash savings and a high FICO score (700 or higher) and a low debt-to-income ratio.
Klein is quick to point out that interest-only mortgages aren’t for everyone. “Some people think interest-only loans will help them buy more house or that they can afford more,” he says. That’s not always the case since the standards are more stringent. “Qualifying for interest-only loans is much harder in qualifying for a normal, qualified mortgage [like a more traditional 30-year mortgage],” he explains. Often, the standards for an interest-only mortgage will include higher credit scores, more cash reserves and assets, and higher household income than a traditional amortized loan, which means a portion of the monthly mortgage payment goes toward the principal. After the Great Recession—in part caused by subprime loans for people who couldn’t afford them—lenders and investors are more cautious about extending interest-only loans.
When you get an interest-only mortgage, you’ll just pay the interest at a fixed rate for a fixed amount of time, giving you a lower payment than a more traditional mortgage on the same loan amount. However, after the initial period expires, the mortgage rate on an interest-only mortgage becomes adjustable, which can significantly drive up your monthly payments. In addition, the payment will also be much higher because it will include principal that must be repaid over a shorter period that the original loan term. That can lead to sticker shock for homeowners who don’t make any principal payments during the initial phase.
Once the interest-only period ends, you can refinance the loan, pay it off in full, or begin paying down the principal in monthly installments for the remainder of the loan term. Unless you were disciplined about making routine principal payments throughout the early payment period, your loan balance won’t go down.
Ready to see if an interest-only mortgage is a good fit for you? Here are some of the benefits.