How Interest-Only Mortgages Work: Pros and Cons

As rising interest rates make home loans more expensive, an interest-only mortgage might look like a good way to lower your monthly payments.

But these mortgages have stricter qualifications than typical principal-and-interest loans, and they're appropriate for only a narrow range of homeowning scenarios.

What is an interest-only mortgage?

An interest-only mortgage requires payments just of the interest — the cost of borrowing money — during the first years of the loan. After the interest-only period, you can refinance or pay off the loan or start making monthly payments of both principal and interest.

At that point, the payments will be higher than if you had paid principal and interest from the beginning. And, unless you opted to pay extra during the interest-only period, you won't have built equity in the home. Before you start repaying the principal, the only equity will be from your down payment and any gain in property value from rising home prices.

Interest-only loans are usually structured as adjustable-rate mortgages. After a specified number of years, the interest rate increases or decreases periodically according to an index. Adjustable-rate mortgages usually have lower starting interest rates than fixed-rate loans, but their rates can be higher during the adjustable period.

» MORE: ARMs vs. fixed-rate mortgages: How to compare

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.

The qualifications for these loans aren’t standardized and can vary widely from lender to lender.

But generally, interest-only mortgage home buyers have:

• High monthly cash flow.

• A rising income.

• Large cash savings.

» MORE: Best interest-only mortgage lenders

Typical uses for an interest-only mortgage

An interest-only mortgage is generally best suited to a buyer in a strong financial position who plans to own the property for a limited time, such as five to 10 years. These loans can also work for people who want flexibility and have the financial discipline to make periodic principal payments during the interest-only period.

For example, an interest-only mortgage could be a good fit for someone who earns large annual bonuses at work and uses those to pay down the principal.

Another 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.

Interest-only mortgages are usually not suitable for typical long-term home buyers, including first-time buyers. Many homeowners got in trouble with interest-only loans during the housing crash in 2008. After their interest-only periods ended, they owed more on their homes than they were worth, and many couldn't afford the higher principal-and-interest payments.

Pros and cons of an interest-only mortgage

Carefully weigh the benefits and drawbacks before considering an interest-only mortgage.

Pros

• The monthly payment is lower during the interest-only period.

• Since interest-only mortgages are usually structured as adjustable-rate loans, initial rates are often lower than those for fixed-rate mortgages.

Cons

• 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 lump-sum payment at the end of the loan term.