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Interest Only Mortgage Basics – How Does It Work?

Interest-only loans are loans that allow people to pay only the interest of a loan during an initial fixed period. Even though this type of loan fell away from the marketplace for a few years, they’ve come back to the surface. in this article, we explain how this type of mortgage works, who could benefit from am interest rate mortgage , advantages and risks
Author: Jack Wickens
Jack Wickens

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Jack is a personal finance writer who has been writing for more than a decade. His passion for educating consumers and helping everyday families earn more and live better. He is most knowledgeable with years of experience covering topics such as savings, budgeting, and responsible credit use and always happy to share his expertise with readers.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

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Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.
Author: Jack Wickens
Jack Wickens

Writer, Contributor

Experience

Jack is a personal finance writer who has been writing for more than a decade. His passion for educating consumers and helping everyday families earn more and live better. He is most knowledgeable with years of experience covering topics such as savings, budgeting, and responsible credit use and always happy to share his expertise with readers.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

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Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

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If you know what it’s like to live through the housing crisis in the late 2008, the phrase “interest-only mortgage will make you tremble. Interest-only loans are loans that allow people to pay only the interest of a loan during an initial fixed period.

This was one of the main reasons why there were so many foreclosures during that period of time. Lenders at that time were approving loans for those who could afford to handle only paying the interest. The downside of that a lot of people lost their homes when it was time for them to pay in full.

According to the Federal Reserve, on mortgages outstanding in the United States between 2001 – 2021, the first quarter of 2021 had the highest outstanding mortgage debt at $16.78 trillion. During the 2007/08 period, the outstanding mortgage debt soared to $14.72 trillion. This chart shows a similar trend during the Covid-19 pandemic in 2020.        

Chart: Mortgage Debt Outstanding in the U.S. 2001-2021 (trillion USD)

Even though this type of loan fell away from the marketplace for a few years, they’ve come back to the surface. As a result, new rules are put in place to ensure that borrowers can truly afford an interest-only loan.

To date, these loans are not for everyone; they are also hard to come by. On a national level, this type of loan only makes up 1 percent of mortgages as a whole as said by the Mortgage Association. If you are considering, here’s what you need to know about interest-only mortgages.

What is an Interest-Only Mortgage?

This kind of mortgage is a mortgage loan that gives an individual the ability to pay only the interest of the principal for a certain period of time. The term period is typically 5-7 years after an individual purchase the home.

When the term is over, that individual has to make the principal-and-interest payment that is amortized during the rest of the mortgage term.

How It Works

The overall picture is that having an interest-only mortgage means that you pay the interest on the loan for a certain period of time. This type of loan will either have a fixed or variable interest rate. The interest rate (on an interest-only adjustable-rate) coincides with a specific benchmark. They coincide specifically with the prime rate, but sometimes with LIBOR, the one-year contract-maturity treasury, or other benchmarks.

They also correspond with the margin; the borrower’s credit score determines its size. The benchmark along with the spread equals the interest rate on the loan. This is called the “fully indexed” rate. Certain ARMs do offer a discounted index rate (which is a teaser rate) during the initial year or so.

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The structures on these loans vary in many different ways. Just realize that the example we just went over is only one of many versions of an interest-only mortgage product.Since interest rates fluctuate regularly, you can apply different scenarios with our interest-only mortgage payments calculator.

Towards the end of an interest-only 10-year loan term, you might have access to refinance your current balance into a new loan if you can get a better interest rate. Moreover, this is an assumption you don’t need to make before taking out an interest-only loan. There are just too many moving parts to try to make a well-educated guess. On top of that, who knows what your interest rate or current situation will look like 10 years from now.

Can I Extend My Interest-Only Mortgage Term?

Your lender may allow extending your interest only mortgage term, by completing an application. This would provide you with additional time to decide if it is possible to move across to a repayment mortgage or wait for investments to mature to cover the capital repayment.

However, your lender will need to see that you can comfortably afford the additional monthly repayments. There may also be other issues that may make your application difficult.  For example, as you will be older than in your initial application, it may go against you. For example, if you’re approaching retirement age, your lender may not approve an extension, since generally, they like the term to end before your 75th birthday.

Can I Sell my House If I Have an Interest-Only Mortgage?

Unless you are tied into a deal that does not allow early repayment, you should be able to sell your home and then simply use the proceeds to repay the capital. There may be some interest penalties or fees imposed for repaying early.

So, it is a good idea to check with your lender and obtain an estimate of the repayable amount before you make a decision to sell. Your lender will also be able to confirm if there are any clauses in your agreement that could prevent the sale.

Interest-Only Mortgage – Example

Here’s an example to understand the concept of how interest-only loans affect your payment. If your bank offers you a $200,000 mortgage at 6%, your monthly payment will be $1199.10. $1,000 is the amount of interest and $199.10 is the repayment of the original $100,000 loan amount. By having an interest-only mortgage, you pay only the interest portion (which is $1,000 in this case.) As a result, this reduces your payment leaving only the principal left to pay. Another thing to note is that interest continues to accrue as well.

Moreover, let’s say that your variable interest rate increases to 7%. Your interest-only payment increases to $1,166.66. For the most part, ARMs have caps. This cap reflects the limit on how high and how low the interest rate can go. It also reflects the amount of money you can move over in a year, month, or quarter. There are cases out there where the interest rate only adjusts upward. The downside is that borrowers will not benefit if the interest rate s fall.

Who Could Benefit From an Interest-Only Mortgage?

Below is the different kind of borrowers that’d be interested in an interest-only loan.

  • Those who desire to decrease their monthly payments. Interest-only loans cater to people who want to only want to lower their payment instead of paying off the loan. It’s also beneficial for those who desire to relocate or downsize before the interest-only period ends.
  • Borrowers that have many variations in their income. Now check this out. The best way to use this type of loan is if you have are in need of cash in the short-term. For instance, an individual that has a seasonal business may want to only pay only the interest while in the off-season.
  • Moreover, this is a good option for someone who is about to graduate with a medical or law degree. Borrowers who know they are going to receive a large amount of stable income can benefit as well. Hayduchok once said that it’s dangerous to get a house more than you can handle is too risky. He suggests that people wait until they have the funds they need before investing.
  • Homeowners that desire to sell their former property. This is very appealing to borrowers who have a brand new home but need to deal with their previous property. When they sell their old property, they have the choice to use the profits to pay a lump sum on their interest-only home loan.
  • For investors and borrowers that have a lot of experience. Now check this out. Beeston once said that interest-only loans are for those who desire to use their cash for other purposes throughout the year. For instance, an investor can decide to use his cash to go towards investing in stock instead. This is money they could use to pay the principal on a conventional loan and use the profits to pay the principal all at once if he/she desires to do so.

Benefits of Interest-Only Home Loans

Here are the short-term benefits of interest-only loans:

  • The payments are low at the beginning of the loan term. This will position you to get the highest amount you can borrow. It can also give you the opportunity to pay off debt that has a higher interest.
  • You’ll get a lot of tax deductions. Now here’s one thing you should now. Investors choose this loan option to receive tax deductions that decrease their tax payable. You can also find out more regarding property investments here.
  • If you need money in the short-term. Interest-only loans are really good for those who have transitional borrowing needs like bridging or construction loans.

Risk of Interest-Only Home Loans

Even though this type of loan appears more affordable because of the low payments, there are disadvantages as well.

  • They cost more. The money that you owe overall doesn’t change during the interest-only period. As a result, you’ll pay a lot more interest on the loan as a whole. Take this for instance. The total cost of interest on a $300,000 mortgage loan over a period of 30 years is $215,608 if the interest is 4%. Similar interest mortgages would total to an amount of $243,334 in interest. If it’s been in “interest-only” for the initial 7 years, you’ll have to pay an additional $27,726.
  • At the end of the interest-only period, the repayments will increase. When the period ends altogether you not only have to continue paying the interest but the principle as well. Since you only have little time to pay it off, the amount you have to pay is often higher.
  • You have no building equity on interest-only home loans. If the property you own doesn't increase in value over a period of time, you run the risk of not having equity for that property toward the period’s end even if you make payments every month. Moreover, you’ll be at a greater risk level if the market is on a downtrend or if your situation leaves you having to sell your house.

Does Adjustable Rate Mortgage a Good Alternative?

An adjustable rate mortgage may be a good alternative to an interest-only loan because it allows you to make lower payments while still paying down the principal on a regular basis.

All ARMs begin with an initial fixed-rate period of 5, 7, or 10 years. During this time, you will receive an initial interest rate that is lower than the fixed rates available at the time, because the market will not have to worry about projecting their return on investment against inflation over the long term. The interest rate, on the other hand, is subject to change.

At the end of this fixed-rate period, your interest rate will be adjusted once per year based on current market conditions. There are a few different indexes used depending on the mortgage investor. The index number is then multiplied by a margin to determine your annual rate.

If you are still living in the home when the interest rate adjusts, you may be able to refinance into a fixed rate. Otherwise, you can let your rate follow the market's movement. You can also use a calculator in order to understand the difference between the options.

According to data obtained from Freddie Mac, the interest rate on a 30-year conventional mortgage has been on a gradual decline. In 1975, the rate of the 30-year conventional mortgage was 13.74%, and it has declined to 3.08% in 2021. Mortgage lenders lower mortgage rates as a way of stimulating growth in the housing market.

Chart: Rates on 30-Year Conventional Mortgage in the U.S. 1975-2021

Why Lenders Prefer a Conventional Loan?

A conforming loan is a mortgage loan that meets Fannie Mae and Freddie Mac's requirements. Only conventional loans (loans not backed by any type of government agency) are conforming loans at this time.

Knowing the difference between conforming and nonconforming is important for economic reasons. Once a lender has funded your loan, it is typically sold to Freddie Mac, Fannie Mae, or other government-sponsored enterprises.

These entities buy mortgages to help the funding financial institution's liquidity. This allows lenders to get the mortgages “off the books,” allowing them to fund more mortgages. Isn't it lovely?

Nonconforming loans have a much smaller market, so issuing them not only limits the lender's liquidity, but also frequently necessitates in-house servicing, which lenders prefer to avoid.

Final Words

Now here’s the point. Getting an interest-only loan is not a good choice. The reason why people choose this option is if they don’t have the income to make larger payments, but will in the future. Since they have variable interest rates, people expect the amount interest they pay to be lower. Nonetheless, the borrower doesn’t make payments on the principal. The principal will continue to generate interest until the full loan amount is paid back.

These types of mortgages have complex implications. Just like with any loan, it’s important to read the fine print and information about the interest rate. The borrower needs to be aware of possibly being forced to make bigger payments as soon as he or she begins repaying the principal. Regarding ARM’s, lenders must have to present forth how high a person’s monthly can increase to. Also, keep in mind that the principal will accrue interest until it’s paid in full.

Here’s another point to make. Interest-only mortgage loans can be good for those who commit to making payments on the principal periodically. This can also be good for those who receive large annual bonuses that they can use to decrease the principal balance of the loan every year. 

FAQs

The qualifications for interest only mortgages can vary according to the lender. However, generally, you need to have a high credit score and an ability to prove to the lender that you have a plan on how you will repay the principal at the end of the loan term.

This could be investments, endowments or other financial products, or that you plan on increasing the value of the property with improvements to provide sufficient equity.

An interest only mortgage can be a viable option if you have a good to excellent credit rating, are looking to keep your monthly repayments as low as possible and you have an alternate means of repaying the principal balance. Many people consider an interest only mortgage if they are planning on flipping their home, since they can repay the principal when they sell the property.

However, if you plan on staying in your home for a prolonged period and want to keep your costs lower, you may be better suited to a longer term conventional mortgage. Although you will still pay more interest in the long term, you will also be repaying a portion of the capital each month. So, at the end of the term, the loan will be totally repaid.

While you generally need a higher credit score to obtain an interest only mortgage, it should not have any detrimental effects on your credit rating, compared to a conventional mortgage. The lender will still report payments that are made on time to the credit bureaus, so you should not experience any drop in your credit rating.

It is possible to overpay on an interest only mortgage. The additional funds can be applied to your loan principal, which will mean that your interest payment will be reduced.

For example, if you have an interest only mortgage of $155,000 on a 25 year term with an interest rate of 5.59%, your monthly payment would be $722,04. If you pay $800 a month, you’ll be overpaying by $77.96. Over a year, this would reduce the principal by $935.52. This means that the interest rate would then be calculated on a balance of $154,064. While this does not seem like much it would knock approximately $5 off the monthly interest payment. If you continue to pay the $800, you would increase the overpayment and continue to gradually reduce the principal.

However, this is a slow way to repay the debt. If you can afford to pay more each month, you may be better to switch to a repayment mortgage, so you will be paying more off the principal each month and at the end of the 25 years, it would be completely paid off.