Interest-only mortgages are making a modest comeback — but are they a wise move? Understanding how interest-only loans work is key to determining whether this type of mortgage is a good fit for you.
What is an interest-only mortgage?
An interest-only mortgage is exactly what it sounds like: a home loan that allows borrowers to make interest-only payments for a set amount of time, typically between seven and 10 years, at the start of a 30-year term. After the introductory period ends, the borrower begins paying principal and interest for the remainder of the loan term at a variable interest rate.
Leading up to the housing crisis of the late 2000s, homebuyers gave in to the instant gratification of mortgages that allowed them to make interest-only payments at the start of the loan, so long as they took on supersized payments over the long term. In the end, many people lost their homes.
Now that some time has passed, a few lenders are offering these kinds of mortgages, but with much stricter eligibility requirements.
How do interest-only mortgages work?
With an interest-only mortgage, the borrower pays interest at a fixed or adjustable rate during the interest-only period. The interest rates are comparable with what you might find with a conventional loan, but the initial payments are much lower. Borrowers must still pay taxes, insurance and possibly private mortgage insurance (PMI).
Even though you’re only required to pay the interest at first, you still have the option of paying down principal during the loan’s introductory period.
At the end of the initial period, borrowers must repay the principal either in one “balloon payment” at a set date, which can be very large, or in monthly payments with interest for the remainder of the term.
You can refinance after the interest-only period is over, although fees may apply.
Pros and cons of interest-only mortgages
Interest-only loans can be a prudent personal finance strategy under certain circumstances, but they’re not a good idea for everyone. Here are some pros and cons:
- You get more house for your money while buying some extra time to save up until you can afford a larger mortgage. That’s assuming you have a sound plan in place for when those larger payments eventually kick in. Bankrate’s affordability calculator can help you estimate how much house you can afford.
- The initial monthly payments on interest-only loans tend to be significantly lower than payments on conventional loans, and the interest rate may be fixed during the first part of the loan. Bankrate’s interest-only mortgage calculator can help you determine what your monthly payment would be.
- If you plan to move out of your home before the introductory period ends, interest-only loans can help homeowners set aside some extra money for other goals and investments.
- Since mortgage interest is tax-deductible, you may be able to reduce your tax burden.
- Interest-only loans can benefit borrowers who know they’re going to be in a high-paying field in a few years, but may still be in school or completing a residency and will be on a lean budget in the interim.
- The interest-only model may also be a good option for business owners with seasonal income, or professionals who receive regular bonuses and can make a large lump payment during their busy season.
- After the introductory period ends, your interest-plus-principal payments will be much bigger than they would be with a conventional loan. Borrowers may experience payment shock when their monthly payments suddenly double or triple, or if they have to make a sizable balloon payment at the end of the initial period.
- It’s tempting to spend and not invest the money saved during the interest-only portion of the loan.
- As long as you’re only paying interest, you’re not building equity in your home.
- You could become saddled with more house than you can afford, and your eventual income may not match your expectations.
- If your home’s value depreciates, you could end up upside-down on your mortgage.
- You could lose your house if you can’t make payments later in the loan term.
How can I qualify for an interest-only mortgage?
Interest-only loans have been harder to come by since the fallout of the housing crisis. Fewer lenders offer them, and banks have set stricter requirements to qualify.
Banks take on a bigger risk when they offer interest-only mortgages, so lenders look for well-qualified borrowers with a minimum credit score of 700 or higher, a debt-to-income ratio of 43 percent or lower and a down payment of at least 20 percent to 30 percent. They may also scrutinize your assets and future income potential.
Can I change my current loan to an interest-only mortgage?
It is possible to refinance a traditional mortgage to an interest-only loan, and homeowners may consider this option as a way to free up money to put toward short-term investments or an unexpected expense. You would meet the same scrutiny and requirements as you would if applying for a first-time interest-only loan.
The same requirements of refinancing also apply, and some lenders may raise the bar since it is a higher-risk loan.
In any refinance, you will need to receive a home appraisal and pay closing costs and fees. Refinancing can cost 3 percent to 6 percent of the home’s total amount. In addition, if you have less than 20 percent equity in your home, you will be required to pay PMI.
Interest-only mortgages are not ideal for most people, but they can be a useful tool for homeowners who fully understand the risks involved and can exercise extreme self-control. In exchange for having low mortgage payments on the front end, you could eventually face enormous monthly payments that your income doesn’t support — and if you choose not to pay down any principal during the initial period, your home won’t gain equity.
The few banks that offer these loans are picky about who they give them to, as well. You will need to have exemplary credit, substantial assets and high earning potential to qualify.
Overall, if you’re a careful saver who’s in a position to take on a significant monthly payment in the long term, you might be a good candidate for an interest-only mortgage.
Featured image by Johner Images of Getty Images.