Interest-only Mortgages: How Do They Work?

Why would someone choose an interest-only mortgage? There are a few scenarios where it could make sense:

• You’re planning to sell the home once the interest-only period ends.
• You need a smaller monthly payment initially.
• You’ve got sufficient cash reserves to make higher payments later or pay the balance off in full.

Calculating interest-only mortgage payments is fairly straightforward. You simply need to know the amount of the loan and the interest rate on the loan. Checking current mortgage rates can give you an idea of what you might pay, based on the amount you plan to borrow.

An interest-only mortgage could make sense for some homebuyers more than others. In terms of the pros, here are some of the best reasons to consider an interest-only mortgage.

• Initial monthly payments are lower compared to traditional mortgages.
• Lower payments can leave you with more money in your budget to manage expenses each month, pay down debt, or invest.
• You have the option to make extra payments to the principal during the interest-only period, which can reduce what you owe.
• Mortgage interest may be deductible on your tax return, which could reduce your tax liability.²
• Interest-only loans are typically structured as adjustable-rate mortgages, which may result in interest savings, depending on the rate environment.³

Now, why might a homebuyer think twice about an interest-only mortgage? Here are some of the drawbacks to weigh.

• You’re not building any equity by making interest-only payments, as the principal balance does not decrease.
• Once regular monthly payments begin, they can be significantly higher, which could make budgeting more of a challenge.
• An adjustable-rate mortgage may not work in your favor if rates climb higher and in general, you’ll pay more in interest over the life of the loan.
• If your home declines in value, any equity gained from making a down payment could be lost.
• Lenders may have stricter requirements when approving homebuyers for an interest-only mortgage.
  

  Getting an interest-only mortgage

  Interest-only mortgages follow the same guidelines as other mortgages, in terms of what lenders consider for approval. That can include, but is not limited to:

  • Credit scores
  • Income and employment history
  • Debt-to-income (DTI) ratios
  • Savings and other assets
  The difference is that lenders may scrutinize them more closely to better gauge a homebuyer’s risk potential.
  Here’s what you have to keep in mind about interest-only mortgage loans. Once the interest-only period ends, your monthly payment goes up to account for the amount that you’re now expected to pay toward the principal.
  Lenders want to make sure that buyers can handle the higher payment when the time comes. For that reason, they may limit approval for interest-only mortgages to buyers who they’re reasonably sure can afford the loan. For example, you might need to have: a minimum 700 credit score, a down payment equal to 15% or 20% of the purchase price, and a debt-to-income ratio below 36% to qualify.
  If you’re interested in learning how to get the best deal on an interest-only home loan, here are a few tips that can help:
  • Shop around. Lenders aren’t all alike and it’s important to see how different loan options compare. Getting rate quotes from multiple lenders can give you a better idea of what you might qualify for.
  • Improve your credit. A higher credit score could translate to lower rates for an interest-only mortgage loan. A difference of even a half or a quarter percentage point on your annual percentage rate (APR) could result in savings, so it’s worth your time to make sure your credit is in good shape.
  • Check rate trends. As mentioned, interest-only home loans typically have adjustable interest rates. Looking at how rates are trending and whether they’re likely to move up or down in the near future is helpful for determining whether the timing is right to get an interest-only loan.
  • Plan ahead. Once the interest-only period ends, you’ll have to begin making regular principal and interest payments to the loan. Estimating those payments can give you a better sense of what you can truly afford and whether it might be in your interest to try refinancing the mortgage into a new loan when the time comes.
  If you decide to move ahead with an interest-only mortgage, take time to read the fine print carefully. It’s important to know how long your interest-only period lasts, what the regular payment will increase to.

  Interest-only mortgages may save money, but don’t forget the big picture

  Getting an interest-only home loan could make sense if you’re not planning to stay in the home long-term, or you’re confident that you can manage a larger payment later in exchange for a smaller one now. Knowing how interest-only mortgage loans work can help you compare them to other mortgage options when deciding which path to take on your journey to homeownership.