An interest-only mortgage, also known as an IO mortgage, is a type of home loan where you only need to pay the interest for a certain time. After that, you have three options: you can refinance, pay the rest of the money you owe all at once, or start making regular monthly payments.
The advantage of an interest-only mortgage is that it allows you to have lower monthly payments in the beginning when you first own the home. However, there are a lot of downsides to this type of mortgage, and it’s considered risky.
Let me explain how it works and how you can qualify for it.
- Understanding interest-only mortgages
- How do interest-only mortgages work?
- Qualifying for an interest-only mortgage
- Interest-only loan pros and cons
- Should you borrow an interest-only mortgage?
- Interest-only mortgage alternative
Understanding interest-only mortgages
With interest-only home loans, you start off by making smaller monthly payments that only cover the interest part of the mortgage. In contrast, conventional loans follow an amortization schedule where each monthly payment goes towards both the principal (the actual amount borrowed) and the interest.
One of the advantages of an interest-only mortgage is that it offers a lower initial payment. You have the option to stick with this lower payment for up to ten years without making any payments towards the principal amount borrowed.
However, it’s important to note that you will end up paying more in total interest over the life of the loan. Additionally, it’s worth considering that interest-only loans are not considered qualified mortgages, which means there may be stricter requirements to qualify for them.
There are a few reasons why someone might choose to take out an interest-only mortgage. One reason could be that they have another investment opportunity and want to have more cash available.
Another possibility is that they plan to sell or refinance the property within a short period of time or expect to receive a larger sum of money before the interest-only period ends.
In the current market, it is feasible to purchase a home using an interest-only mortgage, sell it before any principal payments are required, and make a profit.
According to Mayer Dallal, a managing director at MBANC, a non-qualified mortgage lender, rising home prices provide an opportunity to benefit from capital appreciation in this manner.
How do interest-only mortgages work?
There are two different periods that make up the borrowing term for an interest-only mortgage loan.
During a specific duration
This usually ranging from three to ten years, you will be making payments solely towards the interest on the mortgage. These payments do not contribute towards reducing the principal amount, and as a result, you will not be building equity in your home.
After the initial period
The loan will switch to an amortization schedule. This means that for the remaining duration of the loan, you will be making larger payments that cover both the principal amount and the interest.
Another possibility is that you might have a balloon payment due at this time, which means you would need to make a substantial payment to settle the remaining balance.
Interest-only mortgages don’t qualify for government-backed programs like FHA, VA or USDA loans. And there are a few other key differences between interest-only and conventional mortgages as well.
According to Doug Perry, the strategic financing director at Real Estate Bees, interest-only loans, often referred to as IO loans, typically have slightly higher interest rates compared to conventional mortgages.
Additionally, the maximum loan-to-value ratios for IO loans are usually lower than those for conventional loans. However, alternative lenders like MBANC, as mentioned by Dallal, may offer loans up to 85% of the home’s value.
It’s important to note that compared to government-backed mortgages, borrowers would generally need more savings to qualify for an interest-only loan.
Furthermore, unless extra payments are made during the initial phase, you can expect to pay more interest overall with an interest-only loan compared to a conventional mortgage.
Below is an example to illustrate the monthly payments for an interest-only loan: Let’s assume you borrowed $200,000 with a 5% APR and a 10-year interest-only period.
| Loan Type | Initial Monthly Payment | Amortized Monthly Payment | Total Interest Paid |
|---|---|---|---|
| 10 Year Interest-Only Mortgage | $833.33 | $1,319.91 | $216,779 |
| Conventional Mortgage (20% down payment) | $858.91 | $858.91 | $149,209.25 |
Note that many interest-only mortgages are adjustable-rate mortgages, which have an APR that varies with the prime rate. So you may not have predictable fixed monthly payments with an interest-only home loan.
Qualifying for an interest-only mortgage
You may think that a mortgage with a lower initial down payment would be easier to qualify for on the same income, but that’s not necessarily the case. In fact, some lenders may have even more stringent requirements.
“As rates continue to creep up, as home prices continue to creep up, interest-only loans become more of an affordability option, but not as a crutch to qualify,” says Dallal, “because we still qualify the individual as if it was a 30-year payment.”
To qualify for an interest-only mortgage loan, you’ll likely need:
1. A good FICO score above 700
2. A low debt-to-income ratio below 36%
3. A down payment of at least 15% (depending on the lender)
4. Sufficient income and assets to repay the loan
Perry emphasizes that when it comes to demonstrating the ability to repay an interest-only loan, various methods can be used. These methods range from traditional paystubs to calculate income to alternative approaches, such as using bank statements to determine income or assess the ability to make the monthly payments.”
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Interest-Only Loan Pros and Cons
Pros
Requires low initial monthly payment
In a conventional home loan, your monthly payments go towards both the interest and the principal amount borrowed. However, with an interest-only mortgage, you only need to make payments towards the interest during the initial phase.
As a result, your monthly payment for an interest-only mortgage will be lower compared to a similar conventional mortgage.
Frees up cash flow for other investments
Having a lower monthly payment with an interest-only mortgage provides you with the opportunity to allocate more of your available income towards investments, potentially allowing your money to grow at a faster rate.
Additionally, if you have funds saved in a retirement account, you may anticipate accessing those funds at the end of the interest-only payment period, providing an additional source of available money.
Allows you to reduce your monthly payment
According to Dallal, the loan will recast or readjust as soon as you pay down the original balance. This means that if you make additional payments during the interest-only period, you can reduce your subsequent amortized payment.
In contrast, with a conventional fixed-rate mortgage, your monthly payment remains the same throughout the loan term.
Offers initial tax benefits
During the interest-only payment phase of an interest-only mortgage, you have the potential to benefit from significant tax savings. This is because you can deduct the mortgage interest on your tax return, which can lead to lower taxable income and potentially reduce your overall tax liability.
Cons
Interest-only payments don’t build equity
Building equity in your home is not possible with an interest-only mortgage unless you make extra payments towards the principal during the interest-only period.
Without such additional payments, you won’t be able to accumulate equity that can be utilized for borrowing purposes, such as obtaining a home equity loan or a home equity line of credit.
Refinancing is not guaranteed
If your home loses value, it could deplete the equity you had from your down payment — that could make refinancing a challenge.
Payments will increase down the road
There are several emphasis to the importance of understanding the loan terms when obtaining an interest-only loan.
It is important to be aware that interest-only loans will eventually convert to an amortized loan after a specific period. This typically happens around ten years from the loan’s origination. Alternatively, there may be a balloon payment due.
You will pay more interest over the life of the loan
Though your initial payment will be smaller, your total interest paid will be higher than with a conventional mortgage.
Lenders may have more stringent requirements
Qualifying for an interest-only mortgage can be more challenging due to potentially higher down payment requirements and stricter credit score criteria. Lenders may scrutinize your creditworthiness more closely.
Additionally, it is important to demonstrate your ability to repay the loan, even when the monthly payment increases after the interest-only period. Lenders will assess your financial stability and ensure that you can handle the higher payments when they come into effect.
Should you Borrow an Interest-Only Mortgage?
You should consider an interest-only loan if…
You are planning to live in the home for a short time
If your intention is to sell your home before the interest-only period concludes, an interest-only mortgage might be a suitable choice, particularly if property values in your area are appreciating.
In such circumstances, the lower monthly payments during the interest-only phase can provide financial flexibility, and you may benefit from potential home value appreciation when selling the property.
You are planning to use the home as a rental or investment property
If you plan to fix and flip or rent the property as a long or short-term rental, you can lower your monthly expenses with an interest-only loan.
You can afford the payments but want more cash flow
If you can recoup the extra interest you’d pay on an interest-only mortgage with another investment opportunity, having the flexibility of lower payments could help you grow your money.
You will be coming into more money by amortization time
If you anticipate having access to funds from sources such as your retirement account, another investment, or an inheritance by the time the interest-only period concludes, an interest-only loan could potentially allow you to purchase a more expensive home.
The lower initial payments during the interest-only period might enable you to allocate your resources elsewhere temporarily, with the expectation of having additional funds available to cover the increased payments later on.
You Shouldn’t Consider an Interest-Only Mortgage if…
You can’t afford the full monthly payment
Eventually, you will have to make payments towards the principal and interest. Don’t assume you’ll be earning enough income at that time. Budget for repayment based on the income you earn today.
You need down payment assistance
If you can’t afford at least a 15% down payment, you’ll want to consider another type of home loan, such as an FHA loan.
You are buying in an area where values are dropping
If home prices are depreciating, you’ll lose equity in your home and have difficulty with refinancing.
You want the most cost-effective mortgage
An interest-only loan is going to be more expensive to finance than a conventional mortgage. If your primary concern is spending the least over the life of the loan, choose another alternative.
Interest-Only Mortgage Alternatives
Hybrid Mortgage
According to Perry, if an interest-only loan doesn’t suit your needs, an alternative option could be a hybrid adjustable-rate mortgage. This type of mortgage offers a lower interest rate than a fixed-rate loan but maintains a fixed rate for an initial period, typically seven or ten years. This can result in lower monthly payments compared to a fully amortized 30-year fixed-rate loan.
However, it’s important to note that once the initial fixed-rate period ends and the interest rate becomes adjustable, your payments can become unpredictable. The fluctuating nature of the interest rate can lead to potential payment fluctuations, which should be considered as a drawback of hybrid adjustable-rate mortgages.
Conventional Fixed-rate Mortgage
If the idea of unpredictable payments is a cause of concern or if your goal is to save money throughout the life of your home loan, a conventional fixed-rate mortgage is a recommended alternative.
With a conventional fixed-rate mortgage, you will secure an interest rate (APR) at the time of application, and your monthly payments will remain unchanged for the entire duration of the loan.
Conventional fixed-rate mortgages are commonly available in 15- or 30-year terms, providing flexibility based on your needs. However, it’s important to note that one potential drawback is that the interest rates for conventional fixed-rate mortgages tend to be higher compared to adjustable-rate mortgages.
FHA Loan
If you find yourself lacking sufficient savings for a down payment required by a conventional mortgage or if your credit score does not meet the qualifications for a conventional loan, an FHA loan could be a viable option.
The requirements for an FHA loan are generally more lenient compared to conventional loans. You can potentially qualify for an FHA loan with fair credit, a down payment as low as 3.5%, and a higher debt-to-income ratio. Additionally, FHA loans can be used to finance multi-family rental properties or properties that need renovations.
It is important to note that FHA loans require mortgage insurance, which increases the overall cost of the loan.
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