How Interest-Only Mortgages Work: Pros and Cons
An interest-only mortgage offers a lower monthly payment at first and is best suited for people with ample assets, good credit and short-term ownership plans.
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In a rising-rate environment, 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.
Did you know...
Interest-only loans are usually structured as adjustable-rate mortgages. After a specified number of years, the interest rate increases or decreases periodically based on a benchmark index plus a fixed margin set by the lender. Adjustable-rate mortgages usually have lower starting interest rates than fixed-rate loans, but their rates can be higher during the adjustable period. Mortgage loans from our partners
on NBKC
NBKC
Min. credit score
620
Min. down payment
3%
on New American Funding
New American Funding
Min. credit score
N/A
Min. down payment
0%
on GO Mortgage
GO Mortgage
Min. credit score
620
Min. down payment
3%
Mortgage loans from our partners
on NBKC
NBKC
Min. credit score
620
Min. down payment
3%
on New American Funding
New American Funding
Min. credit score
N/A
Min. down payment
0%
on GO Mortgage
GO Mortgage
Min. credit score
620
Min. down payment
3%
on Rocket Mortgage
Rocket Mortgage
Min. credit score
580
Min. down payment
3.5%
on Veterans United
Veterans United
Min. credit score
620
Min. down payment
0%
Pros and cons of an interest-only mortgage
Carefully weigh the benefits and drawbacks before considering an interest-only mortgage.
Pros
- Lower monthly payments during the interest-only period
- Initial rates that are often lower than those for fixed-rate mortgage
- More cash to put toward investments, savings or other financial goals
- Flexibility to make principal payments at your discretion
Cons
- No equity buildup during the interest-only period
- Risk of losing down payment equity if home values decline, potentially limiting your ability to refinance
- Larger monthly payments following the interest-only period
- Potential lump-sum payment required at the end of the loan term
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
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.
Good fit examples:
- Someone who earns large annual bonuses and uses them to pay down the principal
- A couple nearing retirement who buys a second home, then later sells their first home and uses the proceeds to pay off the interest-only loan
Not usually a good fit for:
- Buyers who plan to stay in their home long term
- First-time buyers without a large down payment or substantial cash reserves
Did you know...
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. Mortgage loans from our partners
on NBKC
NBKC
Min. credit score
620
Min. down payment
3%
on New American Funding
New American Funding
Min. credit score
N/A
Min. down payment
0%
on GO Mortgage
GO Mortgage
Min. credit score
620
Min. down payment
3%
Mortgage loans from our partners
on NBKC
NBKC
Min. credit score
620
Min. down payment
3%
on New American Funding
New American Funding
Min. credit score
N/A
Min. down payment
0%
on GO Mortgage
GO Mortgage
Min. credit score
620
Min. down payment
3%
on Rocket Mortgage
Rocket Mortgage
Min. credit score
580
Min. down payment
3.5%
on Veterans United
Veterans United
Min. credit score
620
Min. down payment
0%
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