An interest-only mortgage is a type of mortgage in which the borrower is required to pay only the interest on the loan for a certain period. The principal is repaid either in a lump sum at a specified date or in subsequent payments.
Key Takeaways
- An interest-only mortgage is one where you solely make interest payments for the first several years of the loan, instead of payments covering both principal and interest.
- Interest-only payments may be made for a specified time period, may be an option, or could last the entirety of the loan term (necessitating a lump sum repayment at the end).
- Typically, interest-only loans are structured as adjustable-rate mortgages.
- While interest-only mortgages result in lower payments initially, they do not contribute to building equity and will result in a significant increase in payments once the interest-only period ends.
Insightful Understanding of Interest-Only Mortgages
Interest-only mortgages can be structured in various ways. Interest-only payments could be applicable for a specified time, offered as an option, or extend throughout the loan’s duration. For some borrowers, the option to pay exclusively the interest may come with specific provisions.
Most interest-only mortgages mandate interest payments for a pre-determined period—usually five, seven, or 10 years. Following this period, the loan switches to a standard payment schedule, incorporating both the interest and a portion of the principal.
Interest-only loans are often modeled as a particular type of adjustable-rate mortgage (ARM), known as an interest-only ARM. Here, the initial repayments cover just the interest, set at a fixed rate, for a number of years known as the introductory period. Post this period, the repayment scheme adjusts to include both principal and interest, and the interest rate starts to fluctuate. For instance, in a “7/1 ARM”, the borrower makes interest-only payments for the first seven years, after which the interest rate revises annually.
Fixed-rate interest-only mortgages are relatively uncommon and are more likely to be found in longer, 30-year mortgages.
Strategies for Paying Off the Interest-Only Mortgage
At the end of the interest-only period, the borrower faces several options. Some may choose to refinance their loan, potentially incorporating new terms and possibly lowering interest payments along with principal repayment. Alternatively, borrowers might decide to sell the mortgaged property to settle the loan. Another choice could be making a one-time lump sum payment, having saved by foregoing principal repayments during the interest-only term.
Special Considerations for Interest-Only Mortgages
Certain interest-only mortgages may feature special provisions. For instance, if significant home repairs are necessary, the borrower might be allowed to make solely interest payments. In some scenarios, only interest might be payable throughout the loan’s duration, necessitating the borrower to handle a considerable lump sum repayment at the end.
Interest-Only Mortgage: Weighing Advantages and Disadvantages
Interest-only mortgages decrease the requisite monthly payment by excluding the principal portion. Homebuyers benefit from improved cash flow and better tools for managing monthly expenses. For first-time homebuyers, this arrangement allows deferring large payments to future years when income is expected to be higher.
However, only paying interest means no equity is being built in the property—equity accrues solely through the repayment of the principal. When principal payments begin, monthly obligations increase significantly. This could pose challenges if aligned with a financial downturn, such as job loss or a medical emergency.
Prospective borrowers should carefully forecast future cash flows to ensure the ability to meet increased payments and fulfill the loan’s terms. While interest-only mortgages are appealing for various reasons, they can also elevate the risk of default.
Related Terms: Adjustable-Rate Mortgage, Fully-Amortized Payment, Principal, Interest Rates, First-Time Homebuyer.
References
- Federal Deposit Insurance Corporation. “Interest-Only Mortgage Payments and Payment-Option ARMs”, Select, What is an I-O mortgage payment?
- Consumer Financial Protection Bureau. “Consumer Handbook on Adjustable Rate Mortgages”, Page 20.
- Consumer Financial Protection Bureau. “What Is an ‘Interest-only’ Loan?”
