What is An Interest Only Mortgage?

Jul 22, 2022

5

min read

W

hen you borrow a loan, you generally have to pay back the loan you borrowed, called principal, and the cost of borrowing the loan, called interest. The principal and interest are packaged into mortgage payments which must be paid in installments to repay the loan. This is a general rule for every loan. But, interest-only mortgages are pretty different from conventional loans.

In this article, we cover everything you need to know about interest-only mortgages:

What Is Interest Only Mortgage?

An interest-only mortgage is typically a loan in which you only have to pay interest for a specific time. You don't have to pay principal during that period. This means you only pay the cost of borrowing the loan, not the actual loan. The loan is later paid in a single payment or installments after the interest-only period ends.

For instance, if you borrow a $50,000 loan at a 5% interest rate, you only need to pay $208 interest monthly. You don't have to pay installments for a $50,000 loan for a certain period as specified.

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How Does Interest Only Mortgage Work?

When you borrow an interest-only mortgage, you only have to pay interest for a certain period, typically 5, 7, and 10 years. After that, the loan will convert into an amortized loan to determine how much principal and interest you have to pay. Then, you must make larger payments for the remainder of the period to fully pay the loan.

Simply, for the specified interest-only period, you are not paying the loan at all. You are just paying interest as a fee to borrow the loan. The actual payment starts after the introductory period ends. So, if you borrow a 30-year interest-only loan with a five-year interest-only period, you are paying a 30-year loan in 25 years.

Also, most interest-only loans are structured as adjustable-rate mortgages (ARM). An ARM loan's interest rate increases or decreases throughout the loan term. The interest is fixed for the interest-only term - the introductory period. After that, the interest rate adjusts, and the payments also change.

For example, If you take out a $200,000 interest-only mortgage at a 5% interest rate for 30 years and an interest-only period for ten years. Then you need to pay interest of $833 for ten years. After that, you need to pay interest as well as principal. The lender will then amortize the loan, and you have to pay monthly payments based on that. After that, you must pay $1,319.91, including the interest and principal.

You can use the interest-only mortgage calculator to determine how much you would need to pay.

Terms For Interest-Only Loans

Most interest-only loans offer an introductory period of some years. Generally, a five or ten-year interest-only period is typical in the USA. After that, the loan will be like a repayment mortgage - paying principal and interest. The only difference would be that you will be making higher monthly payments.

30-Year Interest Only Loan

A 30-year interest-only loan allows the borrower to make interest-only payments for five years and then pay interest and principal for the remaining 25 years.

40-Year Interest Only Loan

A 40-year interest-only loan allows the borrower to make interest-only payments for ten years and then pay interest and principal for the rest of 30 years.

Are Interest-Only Mortgage Rates Higher?

Interest-only mortgages are risky loans for the lenders since the borrowers are not paying off the principal amount for several years. Thus, the interest rates are higher than the conventional mortgage rates.

Likewise, the mortgage is usually structured in adjustable rate mortgages (ARMs). But, the borrower will have to pay fixed interest in the introductory period. After that, the interest rate is adjusted as per the market rate.

However, rate caps limit the interest rate change. The initial interest rate cap is usually 2%. So, if the initial rate is 3%, the after-period interest rate won't be higher than 5%. For any interest rate higher than 5%, the initial interest rate cap is 5%.

Should You Borrow Interest Only Mortgage?

While it seems lucrative to borrow an interest-only mortgage due to its low initial monthly payments, it may not be fit for everyone and every circumstance.

The mortgage can be the best fit for the following circumstances:

First Home Buyer

Buying a first home comes with many expenses. It could be a home renovation, purchasing furniture and decorations, or throwing that housewarming party. On top of that, there is the financial obligation of paying off the house mortgage. An interest-only mortgage can lighten up the financial burden until you become more financially comfortable. At this time, you can make the necessary purchases for the house and save up the money to pay the loan amount later on.

Buy To Sell Intention

An interest-only mortgage is the best fit if you want to purchase a house to sell after a few years. Since you intend to sell before the interest-only period, this will save you the cash flow. You can sell the house at the appreciated value to repay the mortgage later.

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Expectation Of High Future Cash Flow

This mortgage can best fit if you expect high future cash flow. For instance, you could be retiring or graduating from medical college. Although you cannot afford the mortgage payments now, you are sure your financial condition will improve in the future. In such a case, it's best to borrow an interest-only loan.

Investment Strategy

An interest-only mortgage helps you save cash flow. If you can afford the mortgage payments but want to invest the money instead of paying the mortgage loans, then you can opt for the interest-only mortgage.

The mortgage won't be the best fit for the following circumstances:

No Equity Built Up

When you take out a mortgage, you do not entirely own the house until you pay off the loan. After you pay the mortgage payments, you own parts of the house. You are building up the equity, which is your homeownership. But, in an interest-only mortgage, since you are not paying off the loan, you are also not building the equity. This might be a significant issue if you sell or refinance the house, as you do not have complete ownership of your home.

Home Values Are Falling

If the home values fall, an interest-only mortgage is a terrible idea. During the 2008 housing crisis, most homeowners had taken interest-only mortgages to take advantage of the rise in housing prices. But, after the house prices fell, they had no equity but high loan payments. This led to the bankruptcy of many.

Fluctuating Interest Rates

Most interest-only mortgages have variable interest rates. This means the rates vary according to the market rate. If there is fluctuation in the market interest rate, the amount you pay also varies. You might need to pay more payments in the future. Thus, it's better to lock in the interest rate to protect yourself from market uncertainty.

Unstable Income

An interest-only mortgage can be harmful if you have an unstable income. The mortgage may save you some cash flow today, but it will add up debt in the future. If your income is not stable, you might have difficulty making payments down the road.

How To Qualify For Interest Only Mortgage?

Interest-only mortgages are risky loans for the lenders since the borrower will only pay the interest, not the loan balance, for several years. Thus, due to the added risk, there are strict criteria to qualify for the mortgage.

The criteria vary according to the lenders, but you will generally require to meet the following requirements:

A credit score of more than 700.
Debt to income ratio below 36%.
20% down payment on the house.
Sufficient assets.
Sufficient and stable income.
Proper repayment plan.

Applicants need good credit scores and a credit profile to qualify for this type of loan. Lenders will check your income and financial situation to ensure you can afford the higher payments later in the term. They will not only check your current financial status but your future financial position as well. Also, a proper repayment plan for the loan is required to qualify. The repayment plan shows how you aim to repay the loan and can include income and bonus, sale of investments or other assets, endowment policy, and pension.

Where To Apply For Interest Only Mortgage?

An interest-only mortgage is not as widely available as they were before the 2008 housing crisis. Since most mortgage borrowers filed for bankruptcy following the housing market crash, the banks are hesitant to offer this product in modern times.

But, an interest-only loan is a niche product for borrowers with a good credit profile and history. Thus, some lenders still offer the product in the market today. However, there are strict criteria to qualify for the loan.

Here are some lenders that offer interest-only mortgages:

Conclusion

An interest-only mortgage allows the borrower only to pay the interest for several years. After that, the borrower needs to pay back the principal and interest. It helps make initial mortgage payments low but more expensive later. Thus, it is ideal for borrowers who expect substantial future cash flows or investors who want to save their cash flow and invest them. Also, since the mortgage is a risky loan to the lenders, there are strict lending criteria and comparatively higher interest rates.