What Is an Interest-Only Mortgage?

If you need some time to start paying principal payments on a mortgage, consider an interest-only mortgage. With an interest-only mortgage, you’ll pay back the principal as a lump sum at a specified date or in a later set payment schedule. These mortgages are usually a type of adjustable-rate mortgage that can offer greater convenience to certain borrowers. Read on to understand when an interest-only mortgage makes sense and whether it’s the best option for you. 

An interest-only mortgage is a type of mortgage in which the borrower only pays interest for some period or term. After that term, the principal balance is due either in installments or as a lump sum. This differs from other types of mortgage loans in which you pay the principal and interest with each payment. 

When you pay on an interest-only mortgage, you’re not building equity but instead only covering the interest due. Why would you want an interest-only mortgage? Suppose you’re in the process of selling one house, business or asset while buying another. With an interest-only mortgage, you can pay only the interest until you have a lump sum available. 

With lower monthly payments, interest-only mortgages also can make sense for investors who need to spend some time rehabbing a property before renting. During the renovation process, they’ll have lower monthly costs until the house can be rented. 

Interest-only mortgages may be structured in various ways with differing periods of interest only. During the interest-only period, the principal balance remains the same. After the interest-only period, the loan usually converts to a standard schedule in which the buyer’s payments increase to pay down a portion of the principal plus interest each month. In mortgage lender’s terms, this is called a fully amortized basis to the mortgage.

Interest-only mortgages have a set period for interest-only payments ranging from five to 10 years. After that, the principal may be due in full or converted to standard principal payments plus interest. Borrowers also have the option to refinance the mortgage or sell the home mortgaged.

Suppose you plan to invest in a rental property in a growing market and hold it for up to 10 years. You can get an interest-only mortgage with an interest-only period of seven years. The property costs $250,000.

If you make a $25,000 down payment and take a loan for $250,000, for the first seven years, your monthly payments will be $1,125 in interest. If you rent the property for $2,000 per month and average $200 per month for expenses like utilities, maintenance, insurance and taxes, your monthly cash flow is $675. After seven years, when the principal becomes due, suppose the property has appreciated, and you can sell it for $290,000.

After completing the transaction and paying back the loan, you’ll make $65,000. In addition, you would have had a positive cash flow of about $8,100 per year for nearly seven years. During that time, you could recoup your $25,000 down payment and earn a return on investment (ROI) of over 300% on your initial investment over that seven-year period. 

Another option for this example would be a 7/1 loan ratio. With this hybrid home loan, you make fixed monthly payments at a set interest rate for the first seven years. After seven years, the mortgage converts to a variable rate mortgage for the remainder of the loan. 

For many people, paying off the mortgage principal from the beginning of the loan terms makes more sense. But suitable candidates for an interest-only mortgage include those planning to own the home for a short term of under seven years. For example, if you have to move frequently for work, plan to flip the home or plan to sell and purchase a larger home in that time, an interest-only mortgage might make sense. 

Likewise, some buyers choose an interest-only mortgage for rental properties or second homes that they later plan to convert to their primary residence. In that case, you reduce your monthly payments until you can sell the primary residence. 

Factors to consider before opting for this type of loan include total monthly expenses, cash flow and long-term plans for the property. As interest-only mortgages usually require you to either pay the principal in full at the end of the term or refinance, for long-term properties, you risk higher interest rates on a refinance or needing to organize the full principal amount. 

To ensure responsible borrowing and minimize risks, only take loans that keep your total debt-to-income ratio at 50% or less of your income. Ideally, aim to keep it below 30%. If you plan to rent the new property, you can calculate the expected cash flow from rental income. 

Interest-only mortgages have more stringent eligibility requirements for borrowers because banks want to ensure you’re able to pay back the loan when the term is due. That’s why interest-only mortgages aren’t as common as standard repayment mortgages. To secure an interest-only mortgage, you might be asked to show:

• Proof of income
• Savings and investment accounts
• Proof of other assets that could be collateral

There are numerous benefits of interest-only mortgages, including:

• Lower monthly payments 
• Increased short-term cash flow
• Flexibility in financial planning 
• Opportunities to leverage additional funds over a few years.
• Potential tax advantages for certain borrowers
• Deferred payments

The potential drawbacks of an interest-only mortgage center on the deferred principal payments. The main disadvantages include:

• No equity buildup 
• Potential negative amortization
• Higher risk for borrowers during the repayment period
• Possible difficulty in refinancing or selling the property

To avoid these disadvantages, borrowers should be very cautious in calculating future cash flow. Interest-only mortgages can be convenient for several reasons but add to default risk.

Borrowers can consider other types of mortgages, including a traditional mortgage, variable rate mortgage, bank statement mortgage or a nonqualified mortgage. 

A traditional fixed-rate mortgage offers the convenience of fixed monthly payments and building equity from the first month. Variable-rate mortgages can offer an initial period of lower payments, comparable to interest-only mortgages, while building up equity. Consider each based on your financial goals and plans to retain or sell the property in the coming five to 10 years.