If you want a cheaper monthly mortgage payment, just strip it down to its bare bones. That’s what an interest-only mortgage does.
With that benefit in mind, there are also some important drawbacks to consider. For example, it’s harder to qualify for than a typical principal-and-interest loan. And it’s appropriate for a fairly narrow range of homeowning scenarios only.
What is an interest-only mortgage?
An interest-only mortgage requires payments just of the interest — the “cost of money” — that a lender charges. You’re not paying back any of the borrowed money (the principal). That means you’re not building equity in the house except from your down payment or any gain in value that may occur due to local market circumstances.
These home loans are usually structured as adjustable-rate mortgages and frequently have terms of up to 10 years. After that, you’ll have to make amortized payments that are split between interest charges and principal reduction, or pay off the loan, or refinance.
How an interest-only mortgage works
An interest-only loan is offered for a relatively short term, usually five to 10 years. If you remain in the home, you can refinance the loan into a traditional principal-and-interest mortgage, or sign up for another interest-only term.
If you opt for the interest-only loan again, it’s likely your mortgage rate will change. Who knows whether that will be higher or lower?
In the meantime, you haven’t paid down any of the loan balance from your regular monthly payments — unless you’ve opted to make additional payments along the way to reduce the principal. At the end of the final interest-only term, and barring any payments you’ve made separately to the principal, your loan balance is the same as it was when you first signed the mortgage papers.
Who can qualify for an interest-only mortgage?
Compared with a typical principal-and-interest mortgage, interest-only loans often require higher down payments and lower debt-to-income ratios, as well as good-to-excellent credit scores — for example, a FICO score of 700 or higher.
But the qualifications for these loans aren’t standardized and can vary widely from lender to lender.
One thing is for sure: Borrowers will have to show lenders ample assets and a demonstrated ability to pay.
Typical uses for an interest-only mortgage
“Interest-only loans are generally for those folks that are probably not going to be in the property for a long period of time,” says Jim Linnane, president of retail lending at Stearns Lending. “They’re usually thinking in five-, seven- or 10-year increments.”
The best-suited borrowers have cash and liquid investment assets and are in a “very strong financial position,” Linnane says. “The fact that they are not reducing principal is not a danger for them.”
Some typical attributes of interest-only-mortgage home buyers:
Interest-only mortgages can be appropriate for borrowers who are disciplined enough to make periodic principal payments as well. They might also work for someone with a job that pays large annual bonuses that can be used to pay down the principal balance of the loan each year.
Another example of a possible use: A couple nearing retirement might use an interest-only loan to buy a second home, then sell their first home at retirement, move to the vacation home and pay off the interest-only loan.
“Very few people should be really considering an interest-only loan.”
Jim Linnane, president of retail lending at Stearns Lending
But interest-only mortgages are usually not suitable for typical long-term home buyers, including first-time buyers.
“Very few people should be really considering an interest-only loan. It’s usually a cash-flow management tool for wealthier borrowers that feel like they can use their capital and get a better return than the rate that they’re paying on their mortgage,” Linnane says.
Interest-only mortgages aren’t as common as they were a few years ago. Since 2015, after lender abuse that helped fuel the housing crash, Fannie Mae and Freddie Mac stopped purchasing these loans. Lenders have to hold them on their own books or sell them to other investors.
Pros and cons of an interest-only mortgage
When weighing the pros and cons of an interest-only mortgage, keep in mind:
A lower monthly payment during the interest-only term.
Since interest-only mortgages are usually structured as adjustable-rate loans, initial rates are often lower than those for fixed-rate mortgages.
You don’t gain any equity in your home while making interest-only payments.
If market values decline, you could lose any equity in your home provided by your down payment — and perhaps any opportunity to refinance.
Unless you move, you’ll face much larger monthly installments down the road, when principal payments are required.
Some interest-only mortgages require a substantial balloon payment, a lump-sum payment at the end of the loan term.