An interest-only mortgage means you only pay interest on a home loan for a specific period, with the most common being the first 5-10 years of the loan. Interest-only mortgages are considered non-conforming loans and are often hard to come by, as they cannot be insured.
In most cases, your interest-only mortgage will be structured at an adjustable rate, meaning the amount of interest you pay will be adjusted to reflect current rates at least once a year. Fixed-rate interest-only loans also exist but are much rarer. Their interest rate will not change once it is set.
How does an interest-only mortgage work?
Interest-only mortgages require the borrower only to pay interest on a home loan for a set period—usually between 5-10 years—after the loan is purchased. Once the interest-only period is up, you must begin paying off the principal and your monthly rates will increase substantially.
For example, if you have a 30-year interest-only mortgage on a $250,000 house, an interest-only period of five years, and an interest rate of 3%, you’ll pay $625 a month during that five-year period—provided the interest rate doesn’t change.
When it comes to types of interest-only mortgages, there are two options: adjustable-rate and fixed-rate.
Adjustable-rate interest-only mortgages
As the name suggests, adjustable-rate mortgages (ARMs) are structured in such a way to accommodate interest rate changes over time, meaning the amount of interest you pay towards your loan will change at least once a year.
While the prospect of rising interest rates may seem risky at first, your rates will never skyrocket egregiously, as all ARMs have rate caps preventing your interest rate from exceeding a certain percentage.
Fixed-rate interest-only mortgages
Fixed-rate interest-only mortgages, on the other hand, do not change over time. Whatever the interest rate was when the loan was purchased will be the rate charged over the full interest-only period.
This type of interest-only mortgage makes the most sense if you’re taking out the loan when interest rates are very low (ideally the lowest you can expect during your lifetime).
Is an interest-only mortgage loan a good idea?
For some homeowners, choosing to go with an interest-only mortgage makes good financial sense and the pros outweigh the cons.
In general, interest-only mortgages are only available to prospective homeowners whom lenders believe are well-suited to them, but even if your lender offers one to you, it may not be the right move for you.
Advantages of an interest-only loan
Some of the advantages of interest-only loans are as follows:
- Low initial payments: since you are only paying the interest on the mortgage loan, your monthly payments will be lower during the first few years.
- Interest rates may be low: most interest-only loans are structured at an adjustable rate, meaning interest rates may decrease over time (and thus the amount you pay).
- Increased cash flow: you don’t have as much money locked up in equity or large payments, so you’ll be able to expand your budget while paying off the loan.
- Faster pay-off: if you make extra payments towards an interest-only loan, you can lower the payment each month as the principal decreases.
Disadvantages of an interest-only loan
However, interest-only loans are not without their drawbacks. Disadvantages of these types of loans include:
- Interest rates change: unless you have a fixed-rate interest-only loan, interest rates may rise over time, meaning the amount of interest you pay on your mortgage will also increase.
- No equity build-up: you aren’t actually building any equity on your home during the interest-only period, so it won’t increase in value until you start making payments towards the principal.
- Low payments don’t last: your monthly payments will increase significantly after the interest-only period has passed.
- Potential loss of equity: if the value of your home declines, you may lose any equity gained from your down payment on the house.
Key Takeaway Before purchasing an interest-only mortgage loan, make sure you understand the advantages and disadvantages and the difference between fixed- and adjustable-rate options.
Should I use an interest-only loan?
If one of your primary goals is keeping housing costs low on a month-to-month basis, an interest-only loan may be a good idea for you, especially if you only plan to own the home for a short period (e.g., you move frequently).
Similarly, it may make sense to purchase an interest-only loan if you are in the process of buying a second home which you intend to make your primary residence in the future. Low payments during the first few years may be desirable if you aren’t actually living in the home yet.
Where can I find an interest-only mortgage loan?
Actually finding an interest-only mortgage loan is more difficult than it sounds. If you happen to be a homeowner with good credit, large cash savings, and a high income, the best place to start looking for an interest-only loan is with your primary bank or financial institution.
Interest-only loans may also be available through independent lenders and mortgage brokers, though you should always verify their reputability before doing business with them.
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Can you pay interest-only on a mortgage?
Yes. While not indefinitely, you can pay interest-only on a mortgage loan over a set period after you purchase the home, usually 5-10 years. During this initial interest-only period, you will only have to make payments towards the loan’s interest—nothing goes toward the actual principal.
How does an interest-only mortgage work?
Interest-only mortgages work by requiring the borrower only to pay interest on the loan for the first 5-10 years. The amount of interest you pay each month may fluctuate at least once a year, depending on whether you have an adjustable- or fixed-rate loan.
After the interest-only period expires, you will start paying towards the principal as well as any remaining interest.