Interest-only loans are offered on fixed rate or adjustable rate mortgages as well as on option ARMs.
Interest-only mortgages have advantages and disadvantages, but before we go any further, let’s start with the basics.
An interest-only mortgage is a payment option in which you pay only the interest for a number of years – usually either 5 or 10 – at the beginning of the loan term. During this period, your principal balance remains the same, and you aren’t required to pay any of it back. You can still make principal payments during this period if you want to, and it can be a good way to get ahead.
Once the initial time frame rounds out, your loan is re-amortized (a fancy word that refers to payment recalculation) to include both principal and interest and have it all paid off by the end of the loan term. In this way, an interest-only loan can help keep your housing payments low during the first few years of home ownership.
The downside to this approach is that your home won’t accrue any equity, making it that much more difficult to secure a home equity line of credit (HELOC) should you choose to do so in the future.
Interest-only loans are structured as a ratio, such as 7/1 or 10/1. For example, a 10/1 loan means that your interest-only period will last 10 years, after which the rate adjusts once per year.
The amount that the rate will change is limited by rate caps, just like any adjustable-rate loan. The cap depends on the loan:
2% for 3/1 and 5/1 loans
5% on 7/1 and 10/1 loans
Fixed interest-only mortgages are less common. With these loans, you still have the introductory interest-only period, but after that, the interest rate does not adjust. This means that, over the life of the loan, you will typically pay less than you would with an adjustable interest-only loan because your rate is fixed. Additionally, you don’t have the same once-per-year adjustment.
There are several reasons people consider interest-only loans. For instance, it might make good financial sense for you, depending on your long-term plans. On a traditional 30-year fixed rate loan, roughly two-thirds of the payment goes toward interest during the first 6 or 7 years of the loan. If your interest-only mortgage rate is low, then you’ve borrowed money at a good rate.
Instead of paying down that low-rate mortgage, the extra money each month from making interest-only payments can be invested in something that would yield a higher rate of return. Depending on the loan amount, you could have access to thousands of extra dollars over the course of several years that could be used for investments or to reduce high-interest credit card debt.
It may also be that you only ever end up paying the interest. Today, Americans stay in their home for an average of 13 years. An interest-only mortgage is sometimes considered an option for people who expect to be in their homes for less than the term of the interest-only period. Many homeowners like the option of making interest-only payments and using the extra money to save for college tuition, make home improvements, buy a much-needed new car, and so on.
Lastly, because mortgage interest is fully tax-deductible for those with loan balances of less than $750,000 (up to $1 million if you bought your home before December 16, 2017), there is a good chance that your entire monthly mortgage payment is deductible if you’re only paying interest.
For all of their advantages, interest-only loans can also have significant drawbacks, including:
They’re only offered under limited circumstances and are considered to be riskier than your standard loan.
If you only make interest payments, when your mortgage resets and you start making principal and interest payments, you’re paying the full principal amount. Your interest payment may also go up since you haven’t paid down any of the principal amount during the first several years.
The adjustable rate could go up, or your income could decline during the interest-only period – or both – putting you in a difficult situation.
Generally speaking, interest-only mortgages are far less common these days than they were during the Great Recession of 2008. In fact, it was interest-only loans were part of what caused so much trouble leading up to the housing bubble burst. Today, few lenders will offer an interest-only loan. Because of this, you’re not likely to find an interest-only loan being offered by government-sponsored lenders like Fannie Mae and Freddie Mac.
If you’re looking for a lower monthly payment, one alternative you might want to take a look at is an adjustable-rate mortgage (ARM).