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With interest-only mortgages, you're only paying interest for the first three to 10 years of the loan before your payment goes up, making these loans pretty risky.
Interest-only mortgages allow for low initial payments, giving you more financial flexibility
Since you're only paying interest on the home loan, you're not building any equity unless you pay more or the home appreciates in value
Once the initial interest-only period ends, you may experience payment shock, making these loans extremely risky
Under traditional mortgage terms, your payments are amortized throughout the loan, meaning you make monthly payments of principal plus interest until the loan is paid off.
With an interest-only mortgage, you’re making interest-only payments for a number of years before you begin paying down the balance of the loan as well. Interest-only loans typically come with a higher interest rate than traditional mortgages but have lower monthly payments during that initial interest period than a traditional mortgage. For borrowers who are eager to own a particular home but need to maintain a monthly cushion of a few hundred dollars, interest-only mortgages can be beneficial.
On the contrary, interest-only mortgages are extremely risky and have been all but phased out as a mortgage product since the 2008 housing crisis.
With interest-only mortgages, your balance doesn’t increase during that initial period, but you’re also not building any equity in the home unless you pay an extra amount each month to go toward your principal or your home appreciates in value. If the interest-only period ends and you can’t afford the increased mortgage payment and your home happens to depreciate in value, you’ll either be stuck paying for a mortgage you can’t afford or selling your home at a loss.
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As we just touched on, an interest-only payment plan lets the borrower make interest-only monthly payments on the mortgage for a period of time — typically three to 10 years — allowing for smaller payments during that initial period. After the interest-only period ends, your mortgage payment will increase even if your interest rate doesn’t. That’s because you’ll begin paying off the loan balance in addition to the interest you were already paying.
Keep in mind, you’ll have the option of paying more than your scheduled payment amount during the interest-only payment period, and any payment increase will go toward paying off the principal balance. That means if your interest-only payment for a given month is $800 and you pay $850, $50 will be subtracted from the loan balance.
Once the interest-only period of the mortgage ends, you’ll have a few different options for paying back the loan:
Say you have a $250,000 mortgage with a 5.5% interest rate and a 3-year interest-only period. For the first three years, you’d have a monthly payment of $1,145.83 — almost $300 less than that of a 30-year fixed rate mortgage.
But understand that, at the conclusion of the interest-only period, your mortgage payments could rise sharply.
Interest-only loans are typically packaged as adjustable-rate mortgages, which means your interest rate could skyrocket after the initial interest-only period. To go back to the last example, even if your rate stays the same, your payment will still go up almost $300 to $1,419.47 in year four. If your interest rate happens to increase by, say, 2% in year four, your payment would go up more than $600.
For all the potential pitfalls of interest-only mortgages, they are a good choice at times. However, in order for that to be the case, the following should generally apply:
If you have a steady cash flow or you expect to earn a significant amount of money by the time the interest-only period ends — either through an income increase or a trust fund payment — an interest-only mortgage could be a good way to save money in the interim.
However, don’t bet all your marbles on what you expect to happen. When you take out an interest-only loan, you’re still agreeing to pay back the loan balance at some point, and if you find you can’t handle the payment increase and you’re not able to sell, you could lose the home and put yourself in financial ruin.
Since interest-only mortgages are generally pretty risky loans, lenders typically require you to be in good financial standing. They also require a down payment of at least 15%, but if you’re able to make a payment of at least 20%, you can avoid private mortgage insurance and you’ll be starting with pretty sizeable equity in the home, which will lessen the sting of not paying down your balance for the next few years. During the interest-only phase of the loan, you can use the money you’re saving to either pay down more of the loan or other investments.
If you have an unpredictable income — maybe you get commission or only get paid per project — and want some flexibility with your mortgage payment amounts, an interest-only mortgage could make sense.
For example, maybe you do freelance work on film sets and you expect to have months throughout the year when you don’t have work. An interest-only mortgage payment could give you a little more financial flexibility during those months you’re not working. Conversely, if you made a fortune off a single project, you may elect to make a higher payment to pay off some of the balance.
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There’s a reason why certain mortgage products, like payment-option ARMs and interest-only mortgages, have been gradually phased out of the mortgage industry since the 2008 housing crisis. They’re risky!
If you don’t have a high enough income or a steady enough cash flow to buy a $400,000 house, you probably shouldn’t buy a $400,000 house. Interest-only mortgages make the $400,000 house seem more affordable to people who have no business buying a home that expensive; once the initial interest-only period ends, the loan can become wildly unaffordable.
Here are some factors that might make you hesitate before taking out an interest-only mortgage:
Payment shock is what happens when the mortgage payment increases to an unexpectedly high amount during the adjustment period. In the case of interest-only mortgages, that payment shock could happen as soon as the interest-only portion of the loan ends. Not only do you now have to pay back the principal, but your interest rate could also go up during that initial adjustment which would increase your payment even more.
To offset some of the risk associated with interest-only mortgages, lenders typically charge a higher interest rate and require higher down payments. Your mortgage payment will still be lower during the interest-only phase than a traditional mortgage payment, but you’ll still be paying more toward interest over the long term than you would for an amortized mortgage.
Another thing to keep in mind is if you can afford a higher down payment anyway, a traditional fixed rate or hybrid mortgage may be a better bet. If you’re using the home as an investment property, for example, and are looking to keep your monthly payments low, consider looking into something like a 5/1 ARM. These loans typically have lower interest rates than fixed rate mortgages, giving you your monthly savings while allowing you to accumulate equity in the home.
It’s common for borrowers to take out hybrid ARMs (adjustable-rate mortgages with an initial fixed rate period) and interest-only mortgages for short-term homes or fixer-uppers that they intend to flip once the home increases in value. Once the low mortgage payment period ends, the thinking goes, you sell the home and end up with a profit (assuming you have positive equity).
The problem is, in a buyer’s market, flipping a home at a profit isn’t always a guarantee. Considering that you’re only paying interest on the home during that initial period, using interest-only mortgages to buy and flip investment properties is an especially risky strategy, as you’re not accumulating any equity unless you increase your payments or the home appreciates in value.
To the last point, there’s a chance your home could actually depreciate in value during the interest-only period. If you can’t afford the increased mortgage payment at the conclusion of the low payment phase and the home depreciates, you may be left selling the home at a loss.
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