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An interest-only home loan starts out with lower payments, so you might think it's a good option for you. But payments don't stay low forever. Below, we'll discuss what an interest-only mortgage is, how to qualify for one, and some of their pros and cons so you can make the right choice for you.
What is an interest-only mortgage?
An interest-only mortgage is a home loan that at first requires you to only pay interest costs -- not the principal. That means your early payments won't reduce your principal balance. Interest-only mortgages have more affordable monthly payments at first. But payments become much more expensive later on.
After a set period of time -- usually between three and 10 years -- your interest-only period ends. Your loan payments are then recalculated and you'll start paying both principal and interest. The result is a higher monthly payment for the rest of your loan term.
How do interest-only mortgages work?
Interest-only mortgages can be either fixed-rate or adjustable-rate loans. With a fixed-rate loan, your interest rate never changes. An adjustable-rate loan is tied to a financial index. That means your rate can change over time.
Your loan will have a set repayment timeline, such as 30 years. As mentioned, you'll only pay interest for the first several years. Then you'll have to pay principal plus interest, so your monthly payment will increase.
Since your loan balance won't have gone down during the interest-only period, you'll have a shorter time to pay it off, and your payments will be higher. For example, say you pay only interest for the first 10 years and your loan is a 30-year fixed-rate loan. You'll pay down your principal balance for the last 20 years of your loan. Your payments will be higher because you'll have 20 years to pay off the full balance, rather than 30 years. You can use our mortgage calculator to play around with the numbers and see what your payments might be.
Qualifying for an interest-only mortgage
Interest-only mortgages have more risk for lenders since you won't reduce your loan balance for many years. Because of the added risk, lenders have stricter qualifying criteria for this type of home loan.
Requirements vary, but even the best mortgage lenders typically require good or excellent credit. Most also require a larger down payment than you'd need for a traditional mortgage.
Lenders also use the full loan payment amount to calculate your debt-to-income ratio (how much debt you have compared to how much money you earn). That includes principal and interest, even though you're only paying interest to start.
Pros and cons of interest-only mortgages
Here are some of the key advantages and disadvantages of getting an interest-only home loan.
Interest-only mortgage pros
- Lower initial payments: This could free up more money to accomplish other financial goals like saving or investing.
- It's possible to refinance before payments go up: Refinancing down the road might mean you can avoid the higher monthly payments that eventually come with an interest-only mortgage.
Interest-only mortgage cons
- Can be harder to get: You may need a higher credit score and a larger down payment to qualify.
- Payments will go up: Once your interest-only period ends, your monthly mortgage payment will increase. And it will be higher than it would have been if you'd been making both principal and interest payments the whole time.
- It will take longer to build equity: Equity is the value of your home minus what you still owe on your mortgage. Since you'll only pay off interest in the beginning, your first several years of payments will not reduce your loan balance. And that means you won't build equity until you start paying off the principal.
Who is an interest-only mortgage right for?
An interest-only mortgage may be the right home loan if you want to keep your housing costs low and are confident you'll refinance or move before you have to pay both principal and interest costs. It could also be a good option if you don't mind trading higher payments later for lower payments when you take out a home loan. However, you must be a well-qualified borrower to get an interest-only loan.
Still have questions?
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FAQs
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With this type of mortgage, you make only interest payments for the first several years. Once your interest-only period ends, you have to make principal and interest payments. These will be calculated to ensure you pay off your balance within your loan term -- so your payment will rise substantially. It will be higher than it would've been if you had been paying both principal and interest from the start.
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An interest-only mortgage has a fixed or adjustable rate. It also has a set repayment timeline, such as 15 or 30 years. Initially, you only pay interest. You make lower payments each month than you would if you were paying down your principal balance. However, the amount you owe never declines.
Your interest-only period generally lasts between three and 10 years. Once it ends, your payment is recalculated so you pay off your loan in full within the remaining time.
If you pay only interest for the first 10 years and your loan is a 30-year fixed-rate loan, you'll pay your principal balance for the last 20 years of your repayment period. Your payments will be higher because you'll have 20 years to pay off the full balance rather than 30 years.
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An interest-only mortgage may be a good option if you want a lower monthly mortgage payment when you begin paying off your loan. But make sure you're OK with your payment rising substantially when you begin paying principal.
Our Mortgages Expert
Christy Bieber is a full-time personal finance and legal writer with more than a decade of experience. She has a JD from UCLA as well as a degree in English, Media and Communications with a Certificate in Business Management from the University of Rochester. In addition to writing for The Ascent and The Motley Fool, her work has also been featured regularly on MSN Money, CNBC, and USA Today. She also ghost writes textbooks, serves as a subject matter expert for online course design, and is a former college instructor.
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