When you were first introduced to mortgages, you might have learned that there are fixed- and adjustable-rate loans. Fixed-rate mortgages maintain the same mortgage rate throughout the loan period, while ARMs start off with lower interest rates that can change after a set period of time. In both cases, though, you’re making monthly payments toward both the interest and the principal of the loan. But there’s a third option where that’s not the case: an interest-only mortgage.
With an interest-only mortgage, you only pay the interest on your loan for a set period, typically between five and 10 years. This significantly reduces your monthly payment on the front end of your loan. As we’ll see, an interest-only loan has its own pros and cons, just like any other mortgage.
How Interest-Only Loans Work
To fully understand how an interest-only mortgage works, it’s important to be aware of the difference between a loan’s principal and its interest amount.
The principal is equal to the total amount of your loan that you have to pay off – the amount you’ve borrowed to buy your home. This gradually shrinks as you pay it off. Interest is what you owe your lender for borrowing money for a specific period of time.
With interest-only loans, you begin your loan term by only paying interest every month, leaving the principal untouched. Then after a certain amount of time, you’ll owe payments on both the principal and the interest that accumulates.
While your loan term may last for as long as 30 or 40 years, the interest-only portion of the loan generally lasts for just five to 10 years. At the end of that term, you have the option of paying your loan off as if it’s a conventional loan or refinancing if your credit is good enough.
Interest-Only Mortgage Rates Are Often Adjustable
If you’re familiar with adjustable-rate (or variable-rate) mortgages, interest-only loans function in a similar way. Let’s say that your lender takes a look at your financial history and approves you for a 30-year home loan. If that mortgage has an adjustable interest rate, you might initially only have a rate of 2.5% for the first five years. When year six rolls around, your rate might rise to 4.5% (to match the index for your mortgage rate) and could rise up to an interest rate cap, until the whole loan is paid off.
Much like adjustable-rate mortgages, interest-only loans typically begin with temporarily fixed-interest rates that then go up with time. If that same 30-year mortgage mentioned above was an interest-only loan instead, your payment plan might almost look the same. But instead of paying your principal and your 2.5% interest, you’d only be paying for interest for that initial five year-period. Rates for interest-only mortgages tend to vary, but they could end up being higher than traditional loan rates. Your lender might also charge you additional fees for your loan.
The Benefits of Interest-Only Mortgage Loans
Because of your (initially) low monthly home loan payments, interest-only loans might seem like a dream come true. Since mortgage payments tend to account for the largest percentage of monthly bills, the extra money you’d save could be put toward another investment – say, contributing to a retirement account. You might also add the money you save to your emergency fund or start investing in securities or other real estate properties. The money could go to any other financial goal.
You might actually be able to pay off your loan in a shorter amount of time than you would with a traditional loan. That’s because if you decide to pay more than you need to, your payments will automatically go toward reducing your principal balance. Another pro is that you could still qualify for a mortgage interest tax deduction that can cover the entire amount of the payment you make each month.
Interest-only loans could be the ideal mortgages for first-time homebuyers who don’t have a lot of money to contribute upfront and who might already be overwhelmed by all of the other expenses, like closing costs, insurance and a down payment. They might be great for millennials who are interested in buying homes, but remain burdened by student loan debt. Or they could be an option for folks who don’t have a lot of money at the moment but who expect to make more in a few years.
Like variable-rate mortgages, interest-only loans are attractive because they’re adjustable and can work well for people who can’t afford a conventional mortgage payments at the moment. But there are some disadvantages as well that you might want to think about before you agree to shoulder this kind of debt.
Once the interest-only period comes to an end, the sudden jump in your monthly payments may be more than you budgeted for. And if that’s the case, you could risk defaulting on your loan if the payments become too big to bear. Another issue has to do with your home’s appreciation, which is the rise in your houses’s market value over time.
Because you’ll only be paying interest in the beginning of your interest-only loan period, your principal balance won’t change. If your home doesn’t appreciate at the speed you want it to, your mortgage loan could ultimately be higher than the actual value of your home. If that happens, you risk sliding into foreclosure.
The Bottom Line
An interest-only loan is a special type of mortgage that gives borrowers the privilege of only paying interest for a while before having to pay off the rest of the loan. As with any decision, it’s a good idea to think about the pros and cons of these mortgages before committing to them.
They might sound perfect for younger people or aspiring homebuyers who haven’t saved up a large sum of money. Sometimes, they are. However, interest-only mortgages can also problematic for those who won’t have enough down the line to afford the higher monthly payments.
Tips for Buying Your First Home
- Buying a house is a monumental purchase and it’s crucial to make sure that what you’re spending fits in with your overall financial plan. That’s especially true with adjustable-rate or interest-only mortgages, where the payment can change significantly. If you need some help lining up the numbers, consider meeting with a financial advisor. SmartAsset’s financial advisor matching tool can connect you with up to three qualified advisors in your area.
- Mortgage payments are parts of the picture when it comes to financing a home. Make sure you factor in closing costs, down payments and any other fees. Ask your mortgage lender and real estate agent if there are any other fees you should be aware of.
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