What is an interest-only mortgage?

What is an interest-only mortgage?

An interest-only mortgage allows borrowers to make payments only on the interest of the loan for a set amount of time — typically between seven and 10 years — at the start of a 30-year term. After this introductory period ends, the borrower makes payments on the principal and interest for the remainder of the loan term.

How do interest-only mortgages work?

During the introductory period, you’ll pay only interest at a fixed or adjustable rate. Your payments will not include principal, so they’ll likely be much lower than you’d find on a conventional loan — though the interest rate will be comparable.

At the end of the initial period, you must repay the principal either in one balloon payment at a set date, or in larger monthly payments — that include both principal and interest — for the remainder of the term. And, because your principal payments are being amortized over only 20 years instead of 30, those payments will be higher than those of someone with a traditional 30-year loan.

You can refinance after the interest-only period is over, but as in any refinance, you’ll need to receive a home appraisal and pay closing costs and fees, which can total 2 to 6 percent of the loan amount.

Example of an interest-only mortgage

Say you obtain a 30-year interest-only loan for $350,000, with an initial rate of 6.5 percent and an interest-only term of seven years. During the interest-only period, you’d pay roughly $1,896 per month.

After this initial phase, the payment would rise to about $2,610 per month — assuming your rate doesn’t change. Many interest-only loans convert to an adjustable-rate loan, so if rates rise in the future, yours will, too. If your interest-only loan requires a balloon payment instead, you’d be on the hook for several hundred thousand dollars.

With a 30-year fixed-rate mortgage for the same amount, you’d pay $2,212 per month, including principal and interest.

History of interest-only mortgages

In the early 2000s, many homebuyers took on interest-only mortgages, only to find that they couldn’t afford the larger payments after the introductory period. This was one of the risky practices that contributed to the housing crisis in 2007, leading to the Great Recession. In the end, many people lost their homes.

Some lenders still offer interest-only mortgages today, but with much stricter eligibility requirements. They’re now considered non-qualified mortgages, or non-QM loans, because they don’t meet the backing criteria for Fannie Mae, Freddie Mac or the other government entities that insure and repurchase mortgages. Simply put: An interest-only mortgage is a riskier product.

How to qualify for an interest-only mortgage

You’ll need to be well-qualified to be approved for an interest-only mortgage. Banks generally look for borrowers who have:

• A credit score of 700 or more
• A debt-to-income (DTI) ratio of 43 percent or less
• A down payment of 20 percent or more
• Solid proof of future earning potential
• Ample assets

Interest-only mortgage pros and cons

Interest-only loans can be a prudent personal finance strategy under certain circumstances, but they’re not a good idea for everyone.

Pros of interest-only mortgages

• Interest-only payments are smaller than conventional mortgage payments. The initial monthly payments on interest-only loans tend to be significantly lower than payments on conventional loans, and the interest rate may be fixed during the first part of the loan.
• You may benefit from lower rates after the introductory period. If rates fall in the future, you’ll benefit from relatively lower payments when your introductory period ends.
• You may be able to afford higher payments in the future. If you expect your income to increase, you may be able to buy a larger home now and put off the principal payments until they fit your budget. You may also be able to avoid principal payments entirely if you move during the introductory period.

Cons of interest-only mortgages

• You won’t build home equity. As long as you’re paying only interest, you’re not building equity in your home. And if your home’s value depreciates, you could end up upside-down on your mortgage or risk negative amortization.
• You might have an unaffordable payment after the interest-only period. Your payment will increase after the introductory period, and depending on your income, it may not be manageable.
• You’ll be at the mercy of market interest rates. If rates have risen since the loan originated, when the intro period ends, you may have a payment much higher than you expected.

Should you consider an interest-only mortgage?

The best candidates for an interest-only mortgage are borrowers who have full confidence they’ll be able to cover the higher monthly payments when they arise. This kind of home loan might be right for you if you:

• Are in graduate school and want to keep repayments low for now — but anticipate having a high-paying job in the future
• Have a trust that will start releasing assets at a future date
• Flip houses and need to keep expenses down during the remodel
• Expect to move before the end of the introductory period

Alternatives to an interest-only mortgage

If you like some of the features of an interest-only mortgage but don’t think one is for you, you can explore other types of mortgages, including:

• Adjustable-rate mortgages: Like interest-only loans, these mortgages tend to have lower monthly payments during an introductory period. In this case, it’s because of a low, initial rate, which can increase or decrease over time based on market movements. Because payments include principal, you’ll build equity even in the early years of the loan.
• Federal Housing istration (FHA) loans: These government-backed loans are geared toward borrowers who may not qualify for a conventional loan and can offer lower monthly payments without the risk of a future increase.

FAQ

• Do banks still offer interest-only mortgages?

  Yes. Axos Bank, Bank of America, Central Pacific Bank, Chase Bank, KeyBank and New American Funding are examples of large U.S. lenders that offer interest-only mortgages. That said, they’re far less prevalent than before the 2008 housing crisis.

• Can I change to an interest-only mortgage?
  It is possible to refinance a traditional mortgage to an interest-only loan, and borrowers might consider this option as a way to free up money to put toward short-term investments or an unexpected expense. Keep in mind that your lender may have more stringent requirements than for a traditional refinance because it is a higher-risk loan.
• How much can I borrow on interest only?
  The maximum amount you can borrow depends on the interest-only mortgage lender, your financial profile and the type of loan chosen. The loan can either be a conforming loan that has maximum borrowing limits — in most of the country, the 2025 conforming loan limit for one-unit properties is $806,500 — or a jumbo loan that can exceed conforming loan limits. Some lenders allow you to borrow up to 75 to 85 percent of the value of the property and in the seven-figure range.
• What if I can’t pay off my interest-only mortgage?
  If you have an interest-only mortgage, make sure you have a plan in place to repay the principal you borrowed. Failing to do so could leave you with a substantial balance at the end of your mortgage term, potentially requiring you to sell your home. Your lender may attempt to repossess your home through foreclosure if you cannot repay your principal as agreed.

Additional reporting by Kacie Goff