If you want a cheaper monthly mortgage payment, just strip it down to its bare bones. That’s what an interest-only mortgage is.
No payments on principal required
An interest-only mortgage requires payments just to the interest — the “cost of money” — that a lender charges. You’re not paying back any of the borrowed money (the principal).
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
Let’s say you get an interest-only home loan of $500,000, with a initial rate of 5% for five years.
Your interest-only payment would be $2,083.
After five years, the rate becomes adjustable every year, but it is still an interest-only mortgage. Let’s say the rate increases to 6%.
Now, your interest-only payment is $2,500.
The rate continues to adjust annually, and by the end of the tenth year you are required to begin making principal and interest payments, amortized over a 20-year period.
Your monthly principal-and-interest payment, assuming the rate has gradually risen to 7%: $3,876.
There can be many variations on the structure of these loans, so just know that the above example is one version of a possible interest-only mortgage product. And of course, interest rates can go up or down, so you can consider different scenarios with our interest-only mortgage payments calculator.
At the end of the interest-only mortgage term — in this example 10 years — you might be able to refinance the balance into a new loan if a more favorable interest rate is available, but that’s an assumption that you probably shouldn’t make before taking out an interest-only loan. There are too many variables in play to make an educated guess. And who knows how much your situation, and interest rates, may change in 10 years?
Who can qualify for an interest-only mortgage?
Interest-only loans often require higher-than-average down payments, lower debt-to-income ratios and good credit scores — for example, a FICO score of 700 or higher.
But the qualifications of 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.
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Borrowers best suited for interest-only mortgages
“Interest-only loans are generally for those folks that are probably not going to be in the property for a long period of time,” Jim Linnane, director of national sales at Guaranteed Rate, tells NerdWallet. “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:
- High monthly cash flow
- A rising income
- Large cash savings
- Or an income that varies month to month
Interest-only mortgages can be appropriate for borrowers who are disciplined enough to make periodic principal payments. 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 loan.
But interest-only mortgages are not usually suitable for first-time, or typical, long-term home 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.
Another reason 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, the loans haven’t been purchased by Fannie Mae and Freddie Mac. Lenders have to hold them on their own books, or sell them to other investors.
Pros and cons of an interest-only mortgage
- A lower monthly payment during the interest-only term
- Since they are usually structured as adjustable-rate loans, initial rates are often lower than 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 substantial balloon payments, a lump-sum payment at the end of the loan term
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